Alternative asset returns: Apples, oranges and best practices
Time-weighted returns (TWRs) and the internal rate of return (IRR) are not directly comparable—and these different metrics, used by private alternatives (alts) funds with different structures (open-end, perpetual life funds (“open-end”) vs. closed-end, vintage funds (“closed-end”)) can signal different investment outcomes. For comparability, we recommend using the metric net multiples on invested capital (MOICs).
Our analysis suggests private open-end core/core-plus alts funds1 may deliver similar or better net MOICs to median manager private closed-end noncore2 alts funds , with greater transparency and a lower risk profile.
Open-end core/core-plus alts funds benefit from faster capital deployment, being more fully invested for longer, and having more liquidity that can be reinvested or reallocated.
In noncore closed-end alts funds, investing using a multi-vintage program (diversified by vintage) can enhance net returns and reduce risk, but execution is critical and uncertainties abound.
We also believe it is crucial to understand and position alternatives investments in accordance with sources of performance dispersion, as this can potentially generate additional alpha and manage risk.3
Investing in alternatives may be ever more essential, yet comparing returns across different types of alternatives funds—here, we examine core and noncore alternatives —is not straightforward. Returns are calculated differently, in ways not directly comparable, depending on a fund’s structure.
Solving for comparability when fund return metrics differ
Two different alts fund structures typically use different return calculation methodologies:
Open-end, perpetual-life or evergreen funds typically use time-weighted returns (TWRs) to calculate performance, a compound rate of growth that excludes the impact of cash flows. This approach is appropriate for core/core-plus open-end funds as it more accurately measures the performance of an investment manager irrespective of the pacing of invested capital over time, as this is less of a consideration in perpetual-life core/core-plus funds.
Noncore closed-end vintage funds report performance using an internal rate of return (IRR), also referred to as money-weighted return. IRR is more relevant here because IRR considers cash inflows and outflows in solving for a discount rate. This approach is more appropriate for closed-end funds given the greater level of control that managers have over the timing and magnitude of a fund’s cash flows. As a result, it is most appropriate to use a performance measure that reflects this.
TWR and IRR are not directly comparable, in fact they are apples and oranges—comparing performance is less meaningful between funds using the two approaches—and the different metrics can signal very different outcomes for investors. To solve this problem, we recommend investors instead compare net multiples on invested capital (MOICs) over similar time horizons. MOICs are the ending value of investments (including any asset sales or distributions), relative to how much was invested over the time period.
Select examples in Exhibit 1 show why net MOIC is a more meaningful measurement across fund types, as the pace at which capital is invested and/or distributed can materially impact the IRR achieved. Furthermore, a comparable net MOIC can be achieved through a lower TWR, and over a comparable time period (given the faster capital drawdown pace and being more fully invested for longer).
Looking beyond the headline return numbers using net MOIC paints a different picture
EXHIBIT 1: Closed-end fund scenarios vs. an open-end scenario
Efficient capital recycling can improve returns but execution is key
A well-executed capital recycling approach can enhance capital efficiency and improve net MOICs. Exhibit 1 does not capture the impact of reinvesting distributions from closed-end funds, which would impact performance. In a multi-vintage program, capital returned from earlier vintages in the harvest period can be recycled into subsequent funds. Recycling capital efficiently between vintages this way can produce a more fully invested profile over a comparable period, which could improve the program’s performance.
For this reason, we suggest investors consider comparing open-end funds that are reinvesting income to diversified multi-vintage noncore closed-end programs that are recycling capital across vintages. If executed successfully, a diversified multi-vintage program could potentially deliver a slightly higher net MOIC over 10 years than a core/core-plus multi-alts fund. But achieving this outcome requires getting several key factors right. In short, successful execution would be critical for a multi-vintage noncore program—and that is inherently challenging given private markets’ uncertain nature (EXHIBIT 2A and 2B).
A consideration for long-term returns
EXHIBIT 2A: Factors to consider in building a diversified portfolio of closed-end funds
Recycling capital across closed-end noncore funds can improve net MOICs when executed efficiently
EXHIBIT 2B: Expected 10-yr net MOIC, open-end core vs. multi-vintage noncore closed-end funds, with capital recycling
A consideration for long-term returns
We recommend a simple rule of thumb for multi-vintage private noncore alts allocations.
As we have noted, it is incorrect to compare TWRs and IRRs on an absolute basis because they are not directly comparable. IRRs are sensitive to the pacing, timing and magnitude of capital deployed and returned and the length of time capital is invested—cash flows—which are not factors for the TWR metric.
However, using a relatively standard portfolio model over a 10-year period, we can construct a rule of thumb for comparing IRRs and TWRs (Exhibit 3A):
IRR ≈ 2 * TWR
IRR of a single vintage within a multi-vintage construct is roughly twice the TWR that delivers a similar MOIC in a 10-year horizon. The differential is largely attributable to the importance of the timing of cash flows in closed-end funds, and the “j-curve effect.” The j-curve illustrates the turning point, when typically inferior performance in the early years (when fund management fees and expenses outweigh valuation uplift) shifts in the fund’s later years when operational improvements and/or asset sales spur a rise in asset values .5
We reiterate that the variables in Exhibit 2B must be accounted for, and that it is challenging to execute according to plan given private markets’ uncertainties.
A simple rule of thumb: IRR ≈ 2 * TWR
EXHIBIT 3A: MOIC equivalency: Understanding the relationship between TWR and IRRs
EXHIBIT 3B: Impact to net MOIC of various assumed rates of return on idle capital6
Exhibit 3A does not factor in a return for idle capital (committed but not yet deployed) nor capital returned from a noncore closed-end multi-vintage program’s prior investments not yet reinvested. A multi-vintage program has less idle capital than a single vintage, but not a negligible amount. Exhibit 3B illustrates how various assumed rates of return on idle capital would impact the net MOIC and relationship between TWR and IRR (using the 16% single vintage net IRR within a multi-vintage construct from Exhibit 3A). As idle capital get invested in riskier assets, the net MOIC of the multi-vintage program can be improved but this upside comes with a greater downside risk; we demonstrate this by include the VaR (Value-at-Risk) at 95% confidence level for the idle capital proxies.
Generating resilient net multiples on invested capital via an actively managed core/core-plus multi-alts program
The compounding of returns over time is another important consideration in generating long-term sustainable returns in core/core-plus multi-alts funds. Being more fully invested over the longer term and actively reinvesting income distributions can have a meaningful impact on outcomes, potentially by generating higher compounded returns and also as a tool for actively re-positioning the portfolio over time to capture high-conviction views.
Exhibit 4 shows our analysis of the positive impact on net MOICs over time when income is reinvested, rather than taken as a distribution. Reinvesting should lift net MOIC by a widening margin as the period of investment lengthens—illustrating the importance of compounded returns and being fully invested over the long-term. Net MOICs increase by (10% over 10 years; 37% over 20 years; 83% over 30 years).
Analysis suggests reinvesting income increases net MOIC by a widening margin over time
EXHIBIT 4: Expected net MOIC, open-end fund, income reinvested vs. income distributed (years 10–30)
From a risk management perspective, broader is better when allocating to core/core-plus alternatives.7 When core/core-plus alternatives are combined in a multi-alts portfolio, risk metrics, such as volatility and downside risk, should be superior to the underlying strategies’ simple average, due to the noncorrelation among core/core-plus alts funds (EXHIBIT 5).
Diversifying across core/core-plus alts may achieve more resilient long-term outcomes
EXHIBIT 5: Expected volatility, downside risk of core and noncore (avg) and multi-alts funds
We recommend using net MOICs to compare core/core-plus alts fund performance to that of noncore alts funds. Using MOICs, we find these two fund types may deliver similar outcomes. Open-end core/core-plus have greater transparency and a lower risk profile; their faster capital deployment and longer periods being fully invested allow for compounding returns. Using net MOICs, we find that reinvesting/recycling capital in both fund types can impact performance.
In noncore closed-end funds, we find that using a multi-vintage program, diversified by vintage year, may enhance net returns and reduce risk, but execution is a critical challenge.
1 For example, core/core-plus real estate, real assets, credit, and liquid alts that provide forecastable cash flows, low return volatility, public equity diversification, and exposure to high quality counterparties.
2 For example, private equity, distressed credit, and value-added/opportunistic real estate or real assets.
3 This paper is half of a series. The other examines utilizing alts fund dispersion: Pulkit Sharma, Jason DeSena and Richard Wang, “Investing in core/core-plus alternatives: Capturing return dispersion alpha while managing risk” J.P. Morgan Asset Management, July 2022.
4 1.8 – 2.0x for open-end core alts funds assumes investments in single strategies. The range is indicative of the different types of core alternatives (i.e., real estate, infrastructure, transportation, credit, and liquid alts) and corresponding target returns under J.P. Morgan Asset Management’s 2022 Long-Term Capital Market assumptions. 1.8 – 2.5x for multi-vintage long lock-up strategies assumes a 12-18% IRR (median to top quartile PE manager returns) for standalone vintage, JPMAM internal assumptions for cash flows of multi-vintage programs (which are based on a typical single-vintage private equity fund with a 15-year term and with capital fully deployed over a 7-year period), and a 0% return on idle capital. The multi-vintage program assumes that over 90% of capital gets called in the first 4 years (by multiple vintages).
5 Note that this approach is an illustrative comparison that assumes a fully invested open-end fund and a multi-vintage closed-end fund program (to be more representative of an investor’s experience in having an allocation diversified across closed-end funds). By diversifying across multiple vintage years, the impact of single vintage j-curves is partially mitigated and a diversified allocation of private closed-end noncore funds at different stages of their fund life results in a more stabilized investment profile over the long-term.
6 Return and VaR are all based on J.P. Morgan Asset Management’s 2022 Long-Term Capital Market assumptions.
7 Pulkit Sharma, Jason DeSena and Richard Wang, "Investing in core/core-plus alternatives: Capturing return dispersion alpha while managing risk", J.P. Morgan Asset Management, July, 2022.