NISM Series XIX-D Chapter 7 Notes: Fund Performance and Benchmarking

Fund performance is actively monitored by all key stakeholders in the Alternative Investment Fund (AIF) ecosystem, including investment managers, investors, sponsors, trustees, financial institutions, and regulators. Historical performance and risk-return measures are essential tools used for benchmarking, fund allocation, and securing future capital commitments.

To build trust and achieve standardised performance reporting, alternative investment firms are highly encouraged to adhere to the Global Investment Performance Standards (GIPS) formulated by the CFA Institute. Under GIPS, an AIF must report the consolidated performance of all its schemes in different composites based on strategy or investment objectives. The GIPS standards require presenting at least five years of compliant historical performance (or since fund inception), building up to a minimum of 10 years over time, utilizing standardised calculation methodologies.

7.1 Risks in AIFs (Investor Level vs. Fund Level)

The Private Placement Memorandum (PPM) of an AIF must exhaustively outline the risk factors associated with the investment. These risks are broadly categorized into Investor Level Risks and Governance/Fund Level Risks.

7.1.1 Investor Level Risks

1. Risk of Adverse Selection: Choosing the correct fund manager is challenging. Forward-looking statements in PPMs and past track records do not guarantee future fund performance. Choosing an underperforming manager leads to sub-optimal returns or moral hazards.
2. Illiquidity and Uncertainty: AIFs are highly illiquid. Under SEBI regulations, Category I and II AIFs must be close-ended. Investors cannot exit before the scheme winds up, and market stress or poorly timed exits can severely depress asset values.
3. Fund Monitoring Challenges: A lack of robust investment opportunities can curtail performance. Investors can mitigate this by participating in the Investment Management Committee (IMC). Large-ticket and Accredited Investors are often granted IMC representation to monitor risks.
4. Cash Management Risk: Unpredictable capital drawdowns (calls) and exit distributions create cash management challenges for investors, requiring them to maintain liquid cash resources during the drawdown period.
5. Underlying Investment Risks: Portfolio companies carry inherent business, macroeconomic, sectoral, geopolitical, regulatory, and tax risks that are directly passed on to the fund's investors.
6. Debt Financing Risks: AIFs involved in debt financing, distressed debt, or leveraged buyouts face credit risk, default risk, and long recovery timelines.

7.1.2 Governance and Fund Level Risks

1. Structure and Governance Risks: These relate directly to the fiduciary duty of the trustee, investment manager, and service providers (auditors, valuation agencies). Unethical practices, related-party transactions, and a lack of transparency create massive moral hazards.
2. Fund Management Risks: These include the manager's ability to source high-quality transactions, concentration risks from heavy sectoral exposures, poor investment contract structures, and sub-optimal exits.
3. Macro-Level and General Risks: Changes in regulations, tax laws, or the broader economy can harm returns. For example, a sharp depreciation of the Indian Rupee (INR) severely impacts the net returns of foreign investors when converting and repatriating proceeds.

7.2 Specific Types of Risks in AIF Portfolios

Portfolio-specific risks that can lead to permanent capital impairment include:

• Performance Risk: The risk that the fund's research-intensive fundamental analysis fails to result in profitable outcomes due to unknown or changing variables. It also covers key-man risk, where the departure of key investment personnel harms the fund's operational capacity.
• Realisation Risk: The risk that the manager is unable to execute exits at desired valuations because of poor revenue growth in investee companies or unfavorable economic climates.
• Concentration Risk: The risk that the fund holds large, undiversified positions, meaning a single asset default can cause disproportionate losses to the overall scheme corpus.
• Funding Risk: The risk that some investors default on their committed capital calls, forcing the fund to borrow at high interest rates or lose critical transaction opportunities.
• Operational Risk: Systemic failures arising from inadequate internal controls, human error, cybersecurity breaches, and information technology vulnerability.
• Compliance, Legal, and Regulatory Risks: Severe impacts on fund valuations caused by retroactive or unpredictable reforms enacted by SEBI, the RBI, the CBDT, or indirect tax authorities.
• Environmental, Social, and Governance (ESG) Risk: The risk that portfolio companies fail to meet ESG standards. Managers must follow SEBI's Stewardship Code for listed equities to prevent negative signals to global institutional investors.

7.3 Return Measures in Alternative Investments

To assess performance, investors utilize a mix of absolute and time-adjusted return metrics:

1. Holding Period Return (ROI) vs. Internal Rate of Return (IRR)

• Return on Investment (ROI): Measures the absolute return generated relative to cost, but completely ignores the time value of money and cash flow timing.
• Internal Rate of Return (IRR): Accounts for the exact timing of cash outflows (capital calls) and inflows (distributions). It is the discount rate that makes the Net Present Value (NPV) of all cash flows equal to zero. It is highly useful for close-ended AIFs with uneven and unpredictable cash flows.

2. Since-Inception, Gross, and Net IRR

• Since-Inception IRR (or Lifetime IRR): Calculated using all cumulative cash flows from the launch of the fund to the reporting date.
• Gross IRR: Calculated using cash flows at the fund level before deducting management fees, performance incentives, setup costs, and taxes.
• Net IRR: Calculated using cash flows at the investor level after accounting for all fees, expenses, and taxes. Net IRR is always lower than Gross IRR, and the gap can widen significantly in funds with high fixed expenses.

Example 7.1: Comparative Gross vs. Net IRR Analysis

Fund Parameters:

• Fund Corpus: INR 50 crore
• Fund Tenure: 5 years
• Management Fee: 1.5% of year-end Gross NAV (plus 18% GST)
• Setup Costs: INR 1.25 crore (amortized equally over 5 years at INR 25 lakh per year)
• Annual Fund Expenses: INR 30 lakh
• Incentive Fee: 15% above a 10% compounded hurdle rate
• Long-term Capital Gains Tax: 11.96%

Scenario A: Best-Case (Above-Average Returns)

• Year-end Gross NAVs: Year 1: INR 58cr | Year 2: INR 65cr | Year 3: INR 77cr | Year 4: INR 90cr | Year 5: INR 115cr
• Outcome: The fund performs strongly, resulting in high asset appreciation and compounding.
  • Gross IRR = 15.26%
  • Net IRR = 12.77%
  • Absolute Change: 2.49% (a 16% reduction over Gross IRR)

Scenario B: Worst-Case (Below-Average Returns)

• Year-end Gross NAVs: Year 1: INR 55cr | Year 2: INR 54cr | Year 3: INR 59cr | Year 4: INR 65cr | Year 5: INR 70cr
• Outcome: Due to poor asset performance, the fund never crosses the compounded hurdle rate of 10%. The manager receives zero performance incentives.
  • Gross IRR = 5.72%
  • Net IRR = 3.38%
  • Absolute Change: 2.34% (a massive 41% reduction over Gross IRR)

Key Analytical Takeaway:

Fixed operational expenses (management fees, setup costs, audits) create a severe tax-like drag on AIFs. In underperforming funds, this drag is magnified, destroying a massive percentage of the gross yield for the end-investor.

3. Yield to Maturity (YTM)

Commonly used to value fixed-income or debt-oriented AIF investments. YTM represents the IRR of the bond’s cash flows from the purchase date to maturity.

• Effective Interest Rate (Compounding Frequency Formula): Effective Rate = (1 + k / m)^m - 1 (Where k is the nominal rate, and m is the compounding frequency per year).

• Bond Present Value Formula: Bond Value = I * (PVA(r, n)) + F * (PV(r, n)) (Where I is the annual coupon, F is the par value, r is the required return, and n is the years to maturity).

4. The 'J-Curve' Effect

The cash flow and return trajectory of close-ended Category I and II AIFs naturally forms a J-Curve.

• Vintage Years (Years 1 to 3): Cash flows and Net IRRs are strongly negative. Capital is continuously drawn down to buy unlisted assets, while fixed setup costs, audit expenses, and management fees are paid immediately. Realized distributions are non-existent.
• Maturity/Harvesting Years (Year 4 onwards): Portfolio companies grow. The manager executes exits (IPOs, secondary sales, buybacks), triggering positive cash realizations and massive distributions that drive the Net IRR to its peak.

7.4 The Multiples Method (ROI Metrics)

Because unlisted assets are highly illiquid, investors monitor capital realization alongside IRR using four key ratio multiples:

1. PIC (Paid-In Capital) Multiple

Measures how much of the investor's committed capital has been drawn down and deployed by the manager. PIC Multiple = Paid-In Capital / Capital Commitments

• Interpretation: A PIC of 0.80 means 80% of committed capital has been called up, indicating the fund is nearing the end of its deployment phase.

2. DPI (Distributions to Paid-In Capital) Multiple

Also known as the realisation multiple. It measures the cash returned to investors relative to the capital they contributed. DPI = Total Cumulative Distributions / Total Paid-In Capital

• Interpretation: A DPI of 0.40 means investors have received 40 paise in cash for every 1 rupee of capital paid into the fund. Investors prefer early cash distributions to avoid retaining market risks on unrealized gains.

3. RVPI (Residual Value to Paid-In Capital) Multiple

Also known as the unrealised multiple. It measures the remaining estimated fair market value of the fund's active portfolio (the Assets Under Management) relative to contributed capital. RVPI = Assets Under Management / Total Paid-In Capital

• Caution: RVPI relies on estimated unlisted valuations, which carry valuation uncertainty and do not guarantee final cash returns.

4. TVPI (Total Value to Paid-In Capital) / MOIC Multiple

Measures the total economic value created by the fund. It is the aggregate of cash returned and paper gains. TVPI = DPI + RVPI TVPI = (Cumulative Distributions + Valuation of Unrealised Assets) / Paid-In Capital

• Lifecycle Behavior: Before investing begins, TVPI is less than 1.0 due to upfront setup costs and fees. During vintage years, TVPI is driven almost entirely by RVPI. Upon final winding up and full portfolio exit, RVPI falls to zero, and DPI equals TVPI.

7.5 Advanced Performance Metrics (KS-PME and Direct Alpha)

Category I and II AIFs invest in unlisted, illiquid start-ups. To compare their performance against liquid stock markets, two advanced benchmarking models are utilized:

1. Kaplan-Schoar Public Market Equivalent (KS-PME)

The KS-PME measures the relative efficiency of unlisted investments compared to a public equity index (e.g., Nifty 50 or S&P 500).

• Mechanism: It uses the public market index returns to compound all AIF capital calls and distributions to the final valuation date.
• Formula: KS-PME = (Sum of Future Value of Distributions + NAV) / Sum of Future Value of Capital Calls
• Decision Rule:
  • KS-PME > 1.0 👉 The AIF outperformed the public market index.
  • KS-PME < 1.0 👉 The public equity market index generated superior returns.

2. Direct Alpha

Direct Alpha is a variation of the KS-PME that directly quantifies the exact outperformance (or underperformance) of the AIF as a compounded annual percentage rate above the public market index return.

• Direct Alpha = Fund IRR - Market Benchmark Return
• Example: If a fund generates a final IRR of 35% and the public index benchmark return is 25%, the Direct Alpha is 10%.

7.6 Direct and Indirect Tax Impact on AIF Returns

• Direct Taxes: Setting up an AIF within an International Financial Services Centre (IFSC GIFT City) provides significant direct tax concessions compared to general onshore jurisdictions. Similarly, offshore funds domiciliating in jurisdictions with favorable Double Tax Avoidance Agreements (DTAAs) with India (e.g., Mauritius, Singapore, Netherlands) reduce withholding tax liabilities on dividends and capital gains.
• Indirect Taxes (GST Drag): External services provided to the fund (administration, custody, audits, brokerage) and internal management/trustee fees are subject to GST at a standard rate of 18%. Since AIFs do not collect GST on cash distributions to unit-holders, AIFs cannot claim or recover any Input Tax Credits (ITC) on the GST paid. This unrecoverable GST directly increases the fund's operational expenses and reduces investor Net IRR.

7.7 SEBI's Mandatory Benchmarking Framework

Constructing a reliable benchmark for Category I and II AIFs is challenging due to the diverse and highly thematic nature of private equity and venture capital strategies. To address this, SEBI mandated the development of standardised industry benchmarks and the creation of market-wide Benchmarking Agencies.

1. Operational Guidelines for Benchmarking Agencies

• Qualified Agencies: CRISIL, NSE, and Preqin are notified as the official benchmarking agencies.
• Reporting Threshold: Any AIF scheme that has completed at least 1 year from the date of its First Close must report cash flow, performance, and valuation data to the agencies.
• Valuation Standards: Periodicity of reporting is half-yearly (as of September 30 and March 31). March 31 data must be fully audited.
• AUM Definition: For reporting and benchmarking, AUM is defined as the total capital drawn down under the scheme.
• Pre-tax Base: Performance reporting is carried out on the pre-tax Net Asset Value (NAV) of the scheme in both INR and USD terms.
• Vintage Comparison: To ensure fair comparison, funds are grouped and benchmarked based on their respective vintage years (year of First Close).

2. Valuation Integrity Timelines

To ensure the benchmarking agencies receive accurate data, the AIF manager must include terms in the subscription agreement requiring investee companies to provide audited financial statements within a strict timeframe. This enables the AIF to report audited valuations to the agencies within 7 months from March 31st (by October 31st).

7.7.1 Evaluating Alpha via the Capital Asset Pricing Model (CAPM)

The excess return generated by an AIF over its benchmark is evaluated using the CAPM model.

1. Compute the Expected Return [E(R)] of the Fund: Expected Return = Rf + Beta * (Rm - Rf) (Where Rf is the risk-free rate/repo rate, Beta measures systematic risk sensitivity, and Rm is the return of the reference benchmark, such as the CRISIL AIF Index).
2. Calculate Alpha (α): Alpha = Net IRR - Expected Return

Example 7.2: CAPM Expected Return and Alpha Calculation

Scenarios and Inputs:

• Risk-Free Rate (Repo Rate): 6.00%
• Reference Benchmark (CRISIL AIF Cat I Index Return): 9.25%

Step-by-Step Computations:

• Best-Case Expected Return: E(R) = 5.60% + 1.30 * (9.25% - 5.60%) = 10.35% (Note: Expected return calculation in the workbook solution utilizes a baseline Rf of 5.60%).

• Best-Case Alpha: Alpha = 12.77% - 10.35% = + 2.42% (Interpretation: Active management skills added 2.42% of excess return over the risk-adjusted benchmark).

• Worst-Case Expected Return: E(R) = 5.60% + 1.50 * (9.25% - 5.60%) = 11.08%

• Worst-Case Alpha: Alpha = 3.38% - 11.08% = - 7.70% (Interpretation: Unfavorable market conditions and high fixed costs led to a significant underperformance of -7.70%).

Key Formulae & Definitions (Simple Line Format)

• Effective Interest Rate (Compounding): r = (1 + k / m)^m - 1
• Bond Valuation: Value = I * (PVA(r, n)) + F * (PV(r, n))
• PIC Multiple: PIC Multiple = Paid-In Capital / Capital Commitments
• DPI Multiple: DPI Multiple = Total Distributions / Total Capital Contributions
• RVPI Multiple: RVPI Multiple = Assets Under Management / Total Capital Contributions
• TVPI / MOIC Multiple: TVPI = DPI + RVPI
• Kaplan-Schoar PME: KS-PME = (Sum of Future Value Distributions + NAV) / Sum of Future Value Capital Calls
• CAPM Expected Return: Expected Return = Rf + Beta * (Rm - Rf)
• Alpha Generation: Alpha = Net IRR - Expected Return

Key Exam Terms to Remember

• Global Investment Performance Standards (GIPS): Ethical principles formulated by the CFA Institute to ensure standardised, transparent, and comparable performance presentations globally.
• J-Curve: The graphical representation of unlisted close-ended AIF performance over time, characterized by steep negative returns in early vintage years followed by significant positive returns upon maturity.
• DPI Multiple: The realization multiple measuring the exact cash-back ratio returned to investors relative to capital contributed.
• KS-PME: An index-based evaluation tool that compounds unlisted fund cash flows using a public market index to determine whether the unlisted fund outperformed listed equities.
• Unrecoverable GST Drag: The 18% GST levied on management/trustee fees and vendor services which cannot be recovered as input credits, acting as a direct drag on investor yield.