Due diligence on alternatives: interpreting track records, benchmark choice, survivorship bias in indices and reading the KID and prospectus

What you will learn

• Four ways a track record can look better than the investor's experience, with a subscription-line calculation.
• How to benchmark with a public market equivalent (PME).
• Why alternative indices suffer from survivorship and backfill bias.
• A reading order for the KID and the prospectus.

Explanation

Due diligence means checking the facts behind a sales story before committing money. For alternatives the story is usually a track record and an index comparison. IRR, MOIC and DPI were defined in lesson 2 of this course; here we see how they can be shaped.

How track records get flattered

1. Subscription credit lines. The fund borrows to invest and calls investor capital months later. Investor money works for a shorter time, so the IRR rises although the euro profit (and MOIC) is slightly lower after interest. Ask for IRR with and without the line, and look at MOIC and DPI, which timing does not inflate.
2. Unrealised valuations. A young fund's IRR rests on the manager's own marks. Prefer records where DPI (cash actually returned) supports the story.
3. Selective presentation. "Top-quartile in 3 of 4 funds" can mean the manager chose the provider and vintage grouping that made it true.
4. Team changes. A record belongs to the people who produced it. Check that they still run the new fund and look for a key person clause (new investments stop if named partners leave).

Benchmark choice

The public market equivalent (PME) compares a fund with what the same cash flows would have earned in an index: invest each capital call in the index on the same date, sell on each distribution date, compare. The Kaplan-Schoar PME divides index-adjusted distributions by index-adjusted contributions; above 1.0 means the fund beat the index. Match the index to the risk (small caps for buyouts, high-yield bonds for private credit); private funds carry more leverage, so a PME slightly above 1.0 is not a real reward for risk.

Survivorship and backfill bias in indices

Hedge fund indices are built from returns managers report voluntarily. Poor funds stop reporting or close, and their final months are missing (survivorship bias); funds that start reporting after a good start add their earlier history (backfill bias). Result: index returns overstate what an average investor earned and understate volatility. The same biases distort backtests (course "Systematic Trading & Backtesting"); here, ask the provider how it treats funds that stopped reporting.

Reading the KID and prospectus

Funds sold to EU retail investors must provide a three-page PRIIPs key information document (KID). Read: (1) "What is this product?" for legal form and recommended holding period; (2) the summary risk indicator (SRI), 1 to 7, remembering that smoothed valuations can produce a number below the true risk; (3) the performance scenarios (stress, unfavourable, moderate, favourable), which are model outputs, not forecasts; (4) "What are the costs?", especially total cost over the holding period; (5) "Can I take money out early?", where gates and notice periods appear.

In the prospectus go straight to: risk factors; fees and expenses; valuation policy; redemption and gating terms; conflicts of interest (does the manager also lend to or buy from the fund?); and the key person clause. Prospectus duties are covered in the Investor Protection course.

Worked example

Hypothetical example: a buyout fund invests €100 and sells the company for €200 after five years. Fees and taxes are excluded.

1. Without a credit line: −€100 at year 0, +€200 at year 5. IRR = 2.0^1/5 − 1 ≈ 14.9%; MOIC 2.0x.
2. With a credit line: the fund borrows €100 and calls your capital a year later, paying €6 interest from the proceeds. Your cash flows: −€100 at year 1, +€194 at year 5. IRR = 1.94^1/4 − 1 ≈ 18.0%; MOIC 1.94x.
3. The reported IRR is about 3 percentage points higher, while you received €6 less. Ignoring interest, the IRR would be 2.0^1/4 − 1 ≈ 18.9%.
4. PME check: a small-cap index rose from 100 to 150 over the five years. Kaplan-Schoar PME = (€200 ÷ 150) ÷ (€100 ÷ 100) = 1.33. The fund beat the index, but part of the 1.33 pays for buyout leverage and illiquidity.

Common mistake

Practice activity

A fund presentation shows: net IRR 22%, MOIC 1.4x, DPI 0.3x, age 6 years, subscription line used for up to 12 months per deal. Write down three questions you would ask and what each answer tells you.

Key takeaways

• Credit lines, unrealised marks, selective quartiles and team changes flatter track records.
• Benchmark with a PME against a risk-matched index; read MOIC and DPI alongside IRR.
• Voluntary-reporting indices suffer from survivorship and backfill bias.
• In the KID read holding period, SRI, scenarios, total cost and early-exit terms; in the prospectus read risk factors, expenses, valuation policy, redemption terms, conflicts and the key person clause.

Next step

The final lesson brings everything together: an allocation framework for alternatives with a liquidity budget and a due-diligence checklist you can reuse.