Debunking the Allure of Alternative Investments: A Critical Look at Returns and Risk

“Some private equity firms are just larding on the leverage and playing games with the numbers. They talk about internal rates of return, but it's often a lot of balderdash.”

Charlie Munger, Daily Journal Annual Meeting 2019

Debunking the Allure of Alternative Investments_ A Critical Look at Returns and Risk

0:00

The Alternative Investment Boom and the Allure of High Returns

In recent decades, the financial landscape has witnessed a dramatic surge in the popularity of alternative investments. Once the exclusive domain of institutional investors and ultra-high-net-worth individuals, asset classes such as private equity, hedge funds, venture capital, and real estate have increasingly found their way into broader investment portfolios. This shift has been fueled by a pervasive narrative: that these alternative avenues offer superior returns, often with lower volatility, compared to traditional public markets. The promise of uncorrelated assets and enhanced diversification has proven to be a powerful magnet, drawing in trillions of dollars in capital.

However, beneath this alluring facade lies a complex reality that is often obscured by misleading performance metrics and a fundamental misunderstanding of inherent risks. The perception of consistently high returns and understated volatility in alternative investments is, in many cases, an illusion. This blog post will delve into the critical flaws in how these investments are often presented, particularly focusing on the deceptive nature of the Internal Rate of Return (IRR) and the underestimated volatility that characterizes these illiquid assets. We will draw heavily on the incisive research of Ludovic Phalippou, a distinguished professor at the University of Oxford, who has been a leading voice in challenging the conventional wisdom surrounding alternative investment performance.

The Tyranny of IRR: Why Internal Rate of Return Misleads

The Internal Rate of Return (IRR) stands as the predominant metric for evaluating the performance of alternative investments, particularly in private equity and venture capital. In essence, IRR is the discount rate that makes the net present value (NPV) of all cash flows from a particular investment equal to zero. It is a time-weighted measure that accounts for the timing and magnitude of cash inflows and outflows, making it seem like a sophisticated and appropriate tool for assessing long-term, illiquid investments. However, as Ludovic Phalippou and other critics have meticulously demonstrated, the widespread reliance on IRR in the alternative investment space is fraught with significant methodological and practical issues that can lead to a severely distorted picture of actual returns.

One of the most critical flaws of IRR lies in its susceptibility to cash flow manipulation. Fund managers, keenly aware that early cash flows have a disproportionately large impact on IRR, can employ various strategies to artificially inflate this metric. A common tactic involves the use of subscription lines or credit facilities, which allow funds to delay calling capital from investors. By drawing on these lines of credit for initial investments and then repaying them with later capital calls, the fund's net cash outflows appear later in the investment's life, thereby boosting the reported IRR. This practice, while technically legal, creates a misleading impression of early profitability that may not reflect the true underlying performance of the assets. As Phalippou highlights, "Fund managers may time distributions and delay capital calls (through subscription lines and credit facilities) to artificially inflate a fund's IRR, which does not necessarily reflect the underlying performance of the investments" [1].

Another fundamental problem with IRR is its unrealistic reinvestment assumption. The calculation of IRR implicitly assumes that all interim cash flows generated by an investment can be reinvested at the same rate as the calculated IRR. In the context of private equity, where IRRs are often reported in the high double-digits, this assumption is highly improbable. It is rarely feasible to consistently reinvest distributions at such elevated rates, especially given the illiquid nature of these markets and the limited opportunities for immediate, high-return deployments. This overoptimistic assumption inflates the perceived return, making the investment appear more lucrative than it truly is. If cash flows cannot be reinvested at the IRR, the actual return to the investor will be lower.

The sensitivity to timing further exacerbates the misleading nature of IRR. Even small, early cash flows can dramatically skew the IRR upwards, regardless of the overall profitability or the duration of the investment. For instance, a quick, partial exit from an investment early in a fund's life can generate a high IRR, even if the remaining, larger portion of the investment performs poorly over a longer period. This characteristic incentivizes managers to prioritize short-term, high-IRR generating activities over long-term value creation, potentially at the expense of overall fund performance and investor returns.

Finally, the lack of comparability makes IRR a problematic metric for benchmarking and decision-making. Comparing the IRRs of different funds, especially those with varying cash flow patterns, investment horizons, or fee structures, is akin to comparing apples and oranges. Furthermore, directly comparing the IRR of a private market fund to the annualized returns of public market indices is fundamentally flawed. Public market returns are based on daily mark-to-market valuations and continuous liquidity, while private market IRRs are derived from infrequent valuations and illiquid assets. This inherent difference makes direct comparisons misleading and often leads to an overestimation of private market outperformance. Phalippou's research consistently points out that the reported outperformance of private markets over public markets, when measured by IRR, is often a statistical artifact rather than a true reflection of superior returns [2].

In summary, while IRR provides a single, seemingly comprehensive figure, its underlying assumptions and susceptibility to manipulation render it a highly deceptive performance metric for alternative investments. Investors who rely solely on IRR risk making misinformed decisions and harboring unrealistic expectations about the true returns and risks of their private market allocations.

The Illusion of Low Volatility: Unmasking the True Risk

Beyond the misleading nature of IRR, another pervasive misconception surrounding alternative investments is their perceived low volatility. Unlike publicly traded securities, which are marked-to-market daily and whose prices fluctuate with market sentiment and economic news, private assets are valued infrequently, often quarterly or semi-annually, and based on subjective appraisals rather than active trading. This lack of continuous, transparent pricing creates an illusion of stability, leading many investors to believe that alternative investments inherently possess lower risk profiles than their public counterparts. However, as Ludovic Phalippou and other financial academics have argued, this perceived low volatility is not a reflection of true underlying risk but rather a consequence of delayed and smoothed valuations.

The absence of daily mark-to-market pricing effectively hides actual fluctuations and potential losses. When an asset is not continuously traded, its value does not immediately react to adverse market conditions or company-specific news. Instead, any changes in value are gradually incorporated into the infrequent appraisals, leading to a smoothed return series that appears less volatile. This smoothing effect can be particularly deceptive during periods of market stress. While public markets experience sharp declines, private asset valuations may lag, creating a false sense of resilience. Investors might mistakenly conclude that their private equity or real estate holdings are insulated from broader market downturns, when in reality, their true economic value may have diminished significantly, just not yet reflected in the reported figures.

Phalippou has consistently emphasized that just because you do not mark to market daily does not mean it is less volatile. He argues that the illiquidity and infrequent valuation of private assets do not eliminate volatility; they merely obscure it. If these assets were to be traded on an active, liquid market, their prices would undoubtedly exhibit similar, if not greater, fluctuations than comparable public assets, given their often higher leverage and concentration risks. The perceived stability is a function of the measurement methodology, not an intrinsic characteristic of the assets themselves. This hidden volatility can pose significant risks to investors, as they may be unaware of the true extent of their portfolio's exposure to market movements until it is too late.

Furthermore, the underestimated volatility can lead to suboptimal asset allocation decisions. Investors seeking to diversify their portfolios and reduce overall risk might allocate a larger portion of their capital to alternative investments based on their seemingly low correlation with public markets. However, if the true, unobserved volatility of these assets is higher than reported, and their correlation with public markets is also higher than perceived (especially during crises), then the diversification benefits may be significantly overstated. This can leave investors with a riskier portfolio than intended, particularly when liquidity is most needed.

In essence, the illusion of low volatility in alternative investments is a critical aspect of their deceptive allure. It is a byproduct of their illiquid nature and infrequent valuation, rather than an indicator of genuine risk reduction. Investors must look beyond the smoothed reported returns and acknowledge the inherent, albeit hidden, volatility that is an undeniable characteristic of these assets.

Ludovic Phalippou: A Voice of Reason

Amidst the widespread enthusiasm and often uncritical acceptance of alternative investment narratives, Professor Ludovic Phalippou of the University of Oxford’s Saïd Business School has emerged as a prominent and often provocative voice of reason. His extensive research and outspoken critiques have systematically dismantled many of the myths surrounding private market performance, particularly concerning the misleading nature of IRR and the underestimation of true volatility. Phalippou’s work is characterized by rigorous empirical analysis and a commitment to transparency, making him an indispensable resource for anyone seeking a more accurate understanding of this complex asset class.

Phalippou’s key contributions center on exposing the discrepancies between reported alternative investment returns and the actual returns experienced by investors. He has consistently demonstrated that the spectacular IRRs frequently touted by private equity firms are often inflated due to methodological quirks and strategic behaviors. For instance, his research, often conducted in collaboration with other academics, has shown that when private equity returns are adjusted for the unrealistic reinvestment assumption of IRR or compared using public market equivalent (PME) metrics, their outperformance over public markets is significantly less impressive, and in some cases, non-existent, especially after accounting for fees [2]. He argues that a median IRR of 9.1% and a pooled IRR of 12.4% for all private capital funds, as found in one of his studies using a large database, are

good, but not spectacular when compared to long-term US stock market returns, which have averaged around 12% per annum over nearly a century [2].

One of Phalippou’s most significant contributions is his persistent call for more transparent and accurate performance metrics. He advocates for a shift away from since-inception IRR, proposing alternatives such as horizon IRRs or Net Asset Value (NAV)-to-NAV IRRs, which he believes would provide a more realistic and comparable measure of performance. He has also highlighted the importance of considering other metrics like Total Value to Paid-in Capital (TVPI) and Distributed to Paid-in Capital (DPI), which offer a clearer picture of cash-on-cash returns and realized gains, respectively. His work underscores that while these metrics may not always paint as rosy a picture as traditional IRR, they are crucial for investors to make informed decisions based on a true understanding of performance.

Phalippou’s research also extends to the issue of underestimated volatility. He argues that the smoothing of valuations in private markets, due to infrequent appraisals, masks the true risk inherent in these investments. He contends that if private assets were subject to daily mark-to-market valuations, their volatility would likely be comparable to, or even higher than, that of public equities, given their illiquidity and often higher leverage. This perspective directly challenges the notion that alternative investments automatically provide significant diversification benefits due to lower volatility, urging investors to consider the hidden risks that are not immediately apparent in reported figures.

In essence, Ludovic Phalippou serves as a critical counter-narrative to the often-overhyped world of alternative investments. His rigorous academic work provides a much-needed reality check, empowering investors with the knowledge to look beyond superficial metrics and demand greater transparency and accuracy in performance reporting. His insights are invaluable for anyone seeking to navigate the complexities of private markets with a clear and realistic understanding of their true risk and return characteristics.

What Investors Should Consider: Beyond the Hype

Given the inherent complexities and often misleading metrics associated with alternative investments, it is crucial for investors to adopt a discerning and critical approach. Moving beyond the hype and understanding the true nature of these asset classes requires a shift in perspective and a commitment to rigorous due diligence. Here are several key considerations for investors navigating the alternative investment landscape:

Firstly, look beyond reported IRRs to other metrics. While IRR is a widely used metric, its limitations, as discussed, necessitate a broader analytical framework. Investors should demand and scrutinize other performance measures that offer a more comprehensive and accurate picture of returns. These include:

• Total Value to Paid-in Capital (TVPI): This metric, also known as the multiple of money, represents the total value generated by a fund (distributed capital plus remaining net asset value) relative to the total capital called from investors. It provides a straightforward measure of how much an investor has received or expects to receive for every dollar invested.

• Distributed to Paid-in Capital (DPI): DPI specifically measures the cash returned to investors relative to the capital called. This is a crucial metric for understanding realized returns and liquidity, as it focuses on actual cash distributions rather than unrealized valuations.

• Public Market Equivalent (PME): PME methodologies compare the performance of a private market investment to an equivalent investment in a public market index. This helps to address the comparability issue with public markets and provides a more realistic benchmark for assessing outperformance.

• Multiple on Invested Capital (MOIC): Similar to TVPI, MOIC measures the total value created relative to the capital invested in a specific deal or fund. It is often used at the individual investment level.

• Time-Weighted Returns (TWR): While more common in liquid markets, TWR can be a valuable complementary metric for alternative investments, especially for evergreen funds or those with more frequent valuations. It removes the impact of cash flow timing on returns, providing a clearer picture of the underlying asset performance.

By examining a mosaic of these metrics, investors can gain a more holistic understanding of a fund's performance, mitigating the biases inherent in relying solely on IRR.

Secondly, understand the illiquidity premium and its true cost. Alternative investments are inherently illiquid, meaning they cannot be easily bought or sold without significantly impacting their price. This illiquidity is often cited as a reason for their higher returns—the

illiquidity premium. However, investors must critically assess whether the premium they receive adequately compensates them for the lack of access to their capital for extended periods. The true cost of illiquidity includes not only the opportunity cost of capital but also the potential for forced sales at distressed prices if liquidity is suddenly required. The perceived lower volatility of illiquid assets is often a direct consequence of this illiquidity, as values are not marked to market frequently, masking true fluctuations.

Thirdly, be wary of marketing materials and focus on rigorous due diligence. Private market funds often present their performance in the most favorable light, utilizing metrics and presentations that emphasize their strengths while downplaying their weaknesses. Investors should approach these materials with a healthy skepticism and conduct independent, thorough due diligence. This includes scrutinizing the fund's track record, understanding its investment strategy, analyzing its fee structure, and assessing the experience and alignment of interests of the fund managers. Do not hesitate to ask probing questions about how performance is calculated, the assumptions behind valuations, and the true liquidity profile of the underlying assets.

Fourthly, recognize that alternative investments are not a magic bullet for outsized, low-risk returns. The narrative of alternative investments as a panacea for portfolio woes is often oversimplified. While they can play a valuable role in diversification and potentially enhance returns, they come with their own set of risks, including illiquidity risk, valuation risk, and often higher leverage. The notion that they offer consistently superior returns with lower volatility than public markets is largely a myth, especially when accounting for the true cost of capital and the hidden volatility inherent in their structure. Investors should integrate alternative investments into their portfolios with realistic expectations, understanding that they are not a substitute for a well-diversified core portfolio of traditional assets.

Finally, emphasize the importance of understanding the underlying assets and their true risk profiles. Rather than focusing solely on headline performance figures, investors should delve into the specifics of the assets in which a fund invests. What are the fundamental drivers of value for these assets? What are the specific risks associated with them? For example, a private equity fund investing in highly leveraged companies in cyclical industries carries a different risk profile than one investing in stable infrastructure projects. A deep understanding of the underlying assets allows investors to make more informed decisions about whether a particular alternative investment aligns with their risk tolerance and investment objectives.

By adopting these considerations, investors can move beyond the superficial appeal of alternative investments and make more informed decisions based on a realistic assessment of their potential returns and inherent risks.

Conclusion: A Call for Transparency and Realistic Expectations

The allure of alternative investments, driven by the promise of outsized returns and perceived lower volatility, has led to a significant reallocation of capital in the financial world. However, as this exploration has highlighted, much of this allure is built upon a foundation of misleading performance metrics and an underestimation of true risk. The Internal Rate of Return (IRR), while widely used, is a deeply flawed metric that can be easily manipulated and often presents an unrealistic picture of actual returns due to its inherent assumptions and sensitivity to cash flow timing. Similarly, the apparent low volatility of private assets is largely an illusion, a consequence of infrequent valuations rather than an intrinsic characteristic of reduced risk.

Ludovic Phalippou stands as a crucial voice in this discourse, providing rigorous academic research that challenges the prevailing narratives and exposes the statistical artifacts that often inflate reported performance. His work underscores the urgent need for greater transparency and the adoption of more accurate, comparable performance metrics across the alternative investment industry. Without such changes, investors will continue to operate with incomplete and potentially deceptive information, leading to suboptimal allocation decisions and unmet expectations.

For investors, the key takeaway is clear: informed decision-making in the alternative investment space requires a critical and nuanced approach. It means looking beyond the headline IRRs and delving into a broader suite of metrics that provide a more holistic view of performance and liquidity. It necessitates a realistic understanding of the illiquidity premium and the hidden volatility that accompanies private assets. Most importantly, it demands a commitment to thorough due diligence and a healthy skepticism towards marketing claims that promise extraordinary returns with minimal risk.

Alternative investments can indeed play a role in a diversified portfolio, offering unique opportunities and potential benefits. However, they are not a magic bullet. By embracing transparency, demanding accurate reporting, and fostering realistic expectations, investors can navigate this complex landscape with greater confidence and ensure that their allocations are truly aligned with their financial objectives and risk tolerance. The future of alternative investing hinges on a collective move towards greater clarity and a more honest assessment of its true risk-adjusted returns.

References

[1] Phalippou, Ludovic. "The Tyranny of IRR: A Reality Check on Private Market Returns." CFA Institute Enterprising Investor, 8 Nov. 2024, blogs.cfainstitute.org/investor/2024/11/08/the-tyranny-of-irr-a-reality-check-on-private-market-returns/.

[2] Phalippou, Ludovic. "The Hazards of Using IRR to Measure Performance: The Case of Private Equity." SSRN, 27 Mar. 2008, papers.ssrn.com/sol3/papers.cfm?abstract_id=1111796.