From wealth-management
Analyzes alternative investments including hedge funds, private equity, and venture capital. Covers strategies (long/short, macro), metrics (IRR, TVPI, DPI), fees (2-and-20, carry), J-curve, illiquidity premiums, and manager evaluation.
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Analyze alternative investments including hedge funds, private equity, and venture capital. This skill covers strategy classification, fee structure analysis, performance metrics unique to alternatives (IRR, TVPI, DPI), the J-curve effect, illiquidity premiums, and the critical due diligence considerations for evaluating alternative investment managers.
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Analyze alternative investments including hedge funds, private equity, and venture capital. This skill covers strategy classification, fee structure analysis, performance metrics unique to alternatives (IRR, TVPI, DPI), the J-curve effect, illiquidity premiums, and the critical due diligence considerations for evaluating alternative investment managers.
2 — Asset Classes
both
The standard hedge fund fee is "2-and-20" — 2% annual management fee on AUM plus 20% performance fee on profits.
Private equity funds typically show negative returns in the early years because management fees are charged on committed capital, initial investments are carried at cost or slightly written down, and returns have not yet materialized. As portfolio companies mature and are exited, returns improve. The characteristic shape — initial losses followed by gains — resembles the letter J.
PE fund performance is significantly influenced by the economic environment at the time of investment. Spreading commitments across multiple vintage years reduces the risk of investing all capital at unfavorable valuations.
The expected excess return demanded for accepting illiquidity — the inability to sell quickly at fair value. Private equity, venture capital, and certain hedge funds impose lock-up periods (1-10+ years). The illiquidity premium is theoretically 150-400bp for PE and private credit, though estimates vary and are debated.
Many hedge fund returns can be replicated with systematic factor exposure (equity market, size, value, momentum, credit, volatility selling). Research shows that a significant portion of hedge fund "alpha" is actually alternative beta — compensation for well-known risk factors. True alpha (manager skill net of factor exposure) is scarce and diminishing.
Key areas: operational risk (back-office, custody, valuation practices), strategy capacity (can the strategy scale?), manager skill vs factor exposure, transparency and reporting, alignment of interests, and regulatory compliance.
| Formula | Expression | Use Case |
|---|---|---|
| Management Fee | AUM × Management Fee Rate | Annual fee on assets |
| Performance Fee | max(0, Gains Above HWM) × Perf Fee Rate | Fee on profits |
| Net Return (2-and-20) | Gross Return - 2% - 20% × max(0, Gross - Hurdle) | After-fee return |
| TVPI | (Distributions + NAV) / Paid-In Capital | Total return multiple |
| DPI | Distributions / Paid-In Capital | Realized return multiple |
| RVPI | NAV / Paid-In Capital | Unrealized return multiple |
| IRR | Rate r: sum CF_t/(1+r)^t = 0 | Time-adjusted return |
Given: $10M invested, gross return = 8%, 2% management fee, 20% performance fee, no hurdle rate Calculate: Net return and fee drag Solution: Management fee = $10M × 2% = $200,000 Gross profit = $10M × 8% = $800,000 Performance fee = ($800,000 - $200,000 is NOT how it works; fees are typically calculated independently) Performance fee = 20% × $800,000 = $160,000 Total fees = $200,000 + $160,000 = $360,000 Net return = ($800,000 - $360,000) / $10,000,000 = 4.4% Fee drag = 8.0% - 4.4% = 3.6 percentage points
The investor keeps 4.4% of the 8.0% gross return. Fees consume 45% of gross returns in this example. At lower gross returns, the fee drag as a percentage becomes even more severe.
Given: A PE fund calls $2M/year for 5 years (total $10M). Distributions: Year 4 = $1M, Year 5 = $3M, Year 6 = $5M, Year 7 = $8M, Year 8 = $4M. No residual value after Year 8. Calculate: DPI, TVPI, and approximate IRR Solution: Total distributions = $1M + $3M + $5M + $8M + $4M = $21M Total paid-in = $2M × 5 = $10M DPI = $21M / $10M = 2.1x TVPI = (21M + 0) / $10M = 2.1x (no residual, so TVPI = DPI)
Cash flows for IRR: Year 1: -$2M, Year 2: -$2M, Year 3: -$2M, Year 4: -$2M + $1M = -$1M, Year 5: -$2M + $3M = +$1M, Year 6: +$5M, Year 7: +$8M, Year 8: +$4M Solving for IRR numerically yields approximately 18-20%.
The J-curve is visible: negative net cash flows in years 1-4, turning positive in year 5, with the bulk of value returned in years 6-7.