More than ever, we are seeing individuals begin to show more interest in investing in alternative investments. Alternative investments can be hard to define but for the sake of this article, we will focus on Private Equity, Real Estate investments, and other non-traditional investing options. These investments are more complex than traditional investments like stocks and bonds and are therefore harder to evaluate. Frankly, it can be difficult to understand what the potential investment does. It is even more difficult to figure out if it is a good investment factoring in fees, expenses, and other factors. To help you understand how to evaluate an alternative investment, we would like to take a look at two of the more common historical return metrics that can be used to help evaluate alternative investments. However, remember “past performance is not indicative of future returns” and at BFSG we look at many other variables during our due diligence process of alternative investments (some of which are listed below).
Multiple on Invested Capital (MOIC)
Multiple on Invested Capital (MOIC) is a return metric that is important to consider since it is an equity multiple. MOIC measures the performance of an investment relative to its initial cost. Over time the fund will have exit transactions (creates realized value) and assets that are still active (unrealized value) and have not been sold. MOIC can be defined by the following formula:
MOIC = (Realized Value + Unrealized Value)/Initial Investment
It is important to focus on Net MOIC since it factors in fees, expenses and carried interests. It is a more accurate measurement of the return on equity for the Limited Partners (LPs).
Let’s take a look at an example (all numbers are millions):
| Realized Value | $120 |
| Unrealized Value | $20 |
| Capital Invested | $61.2 |
| MOIC | 2.3 |
Key Takeaways
- MOIC helps measure the value a private equity investment is generating.
- It is a quick measure that is easy to understand and compare against similar investments.
- MOIC does not factor in the timing of cash flows (i.e., capital calls or distributions) so it should be used alongside other metrics like Internal Rate of Return (IRR).
Internal Rate of Return (IRR)
Internal Rate of Return (IRR) is one of the most common measures used for evaluating alternative investments. These investments cannot be measured by traditional metrics used to value stocks. IRR is helpful because it considers the timing of cashflows and is an excellent measure of the profitability of an investment. Private Equity and Real Estate investments in particular benefit from using IRR as a performance metric since they deploy capital in the beginning and generate cash flow in the latter stages of the investment. An oversimplified definition of IRR can be boiled down to the growth rate that the investment generates.
To those interested, the formal definition of IRR is the discount rate that makes the net present value (NPV) of future cash flows equal to zero. The best way to calculate this is using excel or a financial calculator. Below is the formula for IRR:
Although IRR looks like an annualized return, making this assumption can be misleading. Because IRR considers the timing of cashflows it can be manipulated to some degree by the General Partner (GP) by controlling the timing of the distributions. The GP is a part-owner of a business who shares in its management. In the case of alternative investments, the business is the alternative investment, and the GP is the company or businesspersons that make decisions or influence the direction of the alternative investment’s management. IRR also assumes all distributions will be reinvested immediately. This is misleading because there is an assumption of built in compounded growth which does not typically occur. Let’s take a look at an example of IRR:
| Fund ABC | ||
| Initial Investment | $ (100,000) | |
| Cash Flow Year 1 | $ 30,000 | |
| Cash Flow Year 2 | $ 30,000 | |
| Cash Flow Year 3 | $ 30,000 | |
| Cash Flow Year 4 | $ 30,000 | |
| Internal Rate of Return (IRR) | 8% |
Key Takeaways
- IRR is the most common metric used to analyze alternative investments.
- IRR is the most common metric to account for the timing of cash flows.
- IRR should be used in conjunction with other metrics to make a sound investment decision.
- IRR can be misleading when comparing alternative investments to one another.
Other Factors to Consider:
Below are some other items to consider when evaluating an alternative investment:
- What are the fees? Often the fees can be as high as 2% per year and on top of that they often take a portion of the returns if the investment returns surpass a certain threshold (know as “carried interest”) stated in the alternative investments offering document (often referred to as a prospectus or private placement memorandum).
- What is the expected lock-up period? These investments are illiquid, so it is important to understand how long the assets are being held and what the exit strategy is for the fund.
- What is the track record of the management team?
- How large is the unrealized portfolio for past funds? If a large portion of a seasoned fund is still unrealized, the manager may be masking low performance, while also raising money for a new fund.
Putting it all together
The best way to determine the value of a potential investment is to look at both the Multiple on Invested Capital (MOIC) and the Internal Rate of Return (IRR). MOIC tells you how the value of an investment has grown on an absolute basis, while an IRR tells you how that investment has generated returns on an annualized basis. This helps paint a more accurate picture when evaluating the cashflow and the potential value that the investment can generate. Let’s take a look at two prospective investments:
| Fund ABC | Fund XYZ | |||
| Initial Investment | $ (100,000) | Initial Investment | $ (100,000) | |
| Cash Flow Year 1 | $ 30,000 | Cash Flow Year 1 | $ – | |
| Cash Flow Year 2 | $ 30,000 | Cash Flow Year 2 | $ – | |
| Cash Flow Year 3 | $ 30,000 | Cash Flow Year 3 | $ – | |
| Cash Flow Year 4 | $ 30,000 | Cash Flow Year 4 | $ 135,000 | |
| Total Gain on Equity | $ 20,000 | Total Gain on Equity | $ 35,000 | |
| Internal Rate of Return (IRR) | 8% | Internal Rate of Return (IRR) | 8% | |
| MOIC | 1.20 | MOIC | 1.35 |
Looking at the two funds, we see the IRR is the same. However, the MOIC of Fund XYZ is higher, implying a greater return on equity than Fund ABC. When completing due diligence, it is important to look at these metrics along with other factors including the factors mentioned above. If you have any questions, please contact us at financialplanning@bfsg.com.
Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.
