“If you’d like to gain a better understanding of Return on Investment, get into gardening” -Hendrith Vanlon Smith Jr. (CEO of Mayflower-Plymouth)
Recently, my wife and I left our daughters (Ruby & Violet) with my in-laws for three days – our longest time away since they were born about 7 and 5 years ago. When we returned home, one of the first things they told me was, “Daddy, we planted a garden! We’re going to grow tomatoes, peppers, and basil, so you won’t have to buy any of those things anymore!”
Before a few minutes ago, I’d never heard of either Mr. Vanlon Smith Jr., but I like his quote. And, speaking of plant-based return on investment (ROI), I’ve put a fair amount of time and effort into growing grass over the years because a) our yard was decimated when we moved in (aka it was mainly just dirt), and b) some areas, like where I removed a sidewalk, required new soil and grass. And I quickly learned there’s a reason the description that something is “like watching grass grow” exists. The process is painful (but admittedly satisfying, if it works).
The outcome of my multi-year effort is that (thankfully) our yard is now at least green. Some of it’s not even grass – it’s clover and whatever green stuff won the survival-of-the-fittest contest in a given section of the yard. BUT, there is one area where I was able to grow nice grass.
While I appreciated our daughters’ green-thumb enthusiasm, I was suspicious, as there isn’t a good place for a garden at our house. So, I immediately inquired, “where did you plant a garden?”
“We planted it where the good grass grows!”
Of course.
Other Return Measures
In Part 1, we talked about TWRR (time-weighted rate of return) and MWRR (money-weighted rate of return), which are essentially used to answer the questions, “what is my return if I ignore cashflows,” or “what is my return, including the impact of cashflows,” respectively. The other return measures we’ll cover today are there to answer the question of “return” from different perspectives, so that’s how I’ll break it down. But keep in mind that this topic can get pretty complex, so we’re still going to keep this at a relatively high level.
ROI: What is my percentage return, based on the amount I invested?
Here we’re talking about return on investment, or ROI. It’s calculated by taking an investment’s dollar gain (or loss) divided by the original investment amount – which is just the percentage gain (or loss). If there aren’t any cash flows after the initial investment, then ROI will be the same as both TWRR and MWRR (caveat: given that these are cumulative returns and NOT annualized returns, as ROI will not be annualized).
If you’re comparing various investments using ROI, it can be helpful IF those investments have similar timeframes. Otherwise, it could be misleading because it ignores time. A 20% ROI over a year sounds like a good investment. A 20% ROI over ten years is much less appealing. The ROI concept can be expanded to consider the impact of time and the time value of money.
CAGR: I get ROI, but what’s my annualized rate of return?
Again, throwing it back to TWRR and MWRR (reminder: this is the same thing as internal rate of return, or IRR), both of those measurements can give us annualized returns on our investment. No, “CAGR” isn’t a reference to parties people used to throw with kegs of beer. It stands for “Compound Annual Growth Rate,” and it’s a more simplistic form of IRR. It’s a way of interpreting ROI as an annual growth rate that accounts for the time (number of years) involved in an investment. The “compound” part compensates for the notion that growth is not linear.
Using our above example of 20% ROI over 10 years, we cannot simply find the annual growth rate by dividing 20% by 10 years (which would be 2% per year). Instead, the answer is 1.84%, as returning 1.84% each year for 10 years results in a total return of 20%. And, you didn’t ask, but 2% per year for 10 years would be a compound return of 21.9% over that timeframe.
NPV: What if I want to compare future income streams and/or values?
If you really want to get into this one, then here’s a place to begin. By using NPV, an investor can account for the time value of money, anticipated cash flows, and future values of a property, company, or other investment. Investment managers in your portfolio may often use it to compare their opportunity set. However, for the average investor, it’s just something to be aware of – not a calculation that will typically come into play for making sense of a portfolio.
How are my illiquid alternative investments doing?
When it comes to Alts –particularly illiquid, drawdown funds – the above measures may not tell the whole story of “how is my fund doing?” Or, it may simply be helpful to look at a given investment through different lenses to assess the situation. Thus, some other return measurements are more Alts-specific, and we’ll get into those now.
MOIC: How many times will (or has) my money multiply(ied)?
MOIC stands for “multiple on invested capital” and is just as it sounds. For every dollar invested, it indicates how many times that amount should be received (or has been received) in return. Thus, a “2x” MOIC means an investment has doubled in value. Like ROI, it’s both straightforward and ignores time. So, similarly, a 2x MOIC may be a fantastic return over the span of a few years, but it wouldn’t be so good over, say, 20 years.
DVPI: How much have I received in distributions relative to what I’ve invested?
In this case, you’re looking for DVPI, or the “distributed-value-to-paid-in” ratio (also known more concisely as DPI, “distributions to paid-in,” or as the “realization multiple”). It’s the total cash flow received divided by the total amount invested. If I invested $10 and received $5 back, the DVPI would be 0.5 ($5/$10). Once the DVPI has reached a value of 1, you’re playing with the house’s money. I think this is a good measure for long-term investments, like GP Stakes, which could be (essentially) perpetual but involve significant cash flow. DVPI will indicate when the original investment has been fully recouped and then the multiples of return above that.
RVPI: How much value is left in the investment relative to what I’ve invested?
You guessed it: RVPI stands for “residual value to paid-in.” The value that remains in an investment vs. the amount invested.
TVPI: What is the total value of my investment relative to what I’ve invested?
Now we’re cooking with gas! Since you’re basically a professional at understanding these ratios by now, I’m sure this needs no explanation. But TVPI stands for “total value to paid-in.” Just like it sounds, it’s everything (cashflows and value) gained vs. what has been invested. I think TVPI is the most useful of the trio of “P.I.” ratios. And, if you want to start calling these the Magnum ratios, I’ll support it. Obviously, these are Tom Selleck’s favorite ways to measure his alternative investments.
PME: Were my Alts ultimately worth it!?
Now for the elephant in the room. The above return measurements ignore what many critics of Alts (often try to) hang their hat on: opportunity cost. That is – for all the effort and costs that go into alternative investments – could someone do just as well investing in a traditional portfolio? It’s a loaded question, as many factors should be considered beyond returns (e.g., investor comfort, income characteristics, volatility, diversification, correlations, illiquidity, etc.), but PME – or “public market equivalent” – at least helps to make a return comparison possible.
Since, in hindsight, we know the cashflows of a given Alt, we can use that information to run a “what if” scenario. For example, what if I modeled the same cashflows (on the same days) as having gone into an S&P 500 index fund? Would my return have been better or worse? That is what PME will tell us. There’s a lot to say on that subject, so perhaps we’ll revisit it in a future Alt Blend.
What really matters
Of course, it’s important to ensure that underlying managers are doing their job and accomplishing what they are supposed to. But what ultimately matters is that your portfolio accomplishes what is needed to allow you to reach your particular financial objectives. And no return measure will provide that information, as it’s a question that can only be answered via comprehensive financial planning.
And, finally, I leave you with an important announcement: this post will be the last Alt Blend for the foreseeable future…
…accompanied by an audio podcast. It will otherwise continue uninterrupted, on a biweekly basis, in written format. As a team, we’re always attempting to weigh the pragmatic allocation of resources, and the audio portion doesn’t seem to warrant the additional production time involved. We welcome any feedback you may have, however.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
