Alternative Investments
Private capital
Private equity valuations use income, market, and asset-based approaches; performance is measured by IRR and multiples such as MOIC and DPI. Early negative cash flows followed by later gains produce the J-curve. Fee structures combine a management fee with carried interest above a hurdle rate, sometimes with a catch-up provision.
Real estate and infrastructure
Direct real estate is valued by the income approach: value = NOI / cap rate, where the cap rate reflects growth and risk. Debt service coverage and loan-to-value drive financing capacity. Infrastructure offers long-duration, often inflation-linked cash flows with regulatory risk.
Hedge funds
Strategies include event-driven, relative value, macro, and equity hedge. Lockups, high-water marks, and hurdle rates shape manager incentives. Due diligence must address backfill bias, survivorship bias, and appraisal-based smoothing, which understates volatility and correlations and overstates Sharpe ratios.
Traps
- IRR assumes reinvestment at the IRR; multiples ignore cash flow timing.
- A hurdle applies only to profits above the threshold; a catch-up lets the GP earn more than a naive split.
- Reported hedge fund index returns are biased upward by survivorship and backfill.
Worked example
A $100 million fund returns 20% gross, with a 2% management fee, a 20% incentive fee, and an 8% hurdle, no catch-up. Management fee = $2 million. Profit above the hurdle = 20 - 2 - 8 = $10 million, so the incentive fee = $2 million and the net return = (20 - 2 - 2)/100 = 16%.
Rule of thumb: for any alternative investment, ask whether the return measure captures timing, fees, and stale pricing before comparing it with public markets.