ROCC & MOCC: Unveiling an Alternative Approach to Private Market Return Analysis

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A Different Way of Understanding Alternative Investment Returns

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Bringing Clarity

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The process of manager selection within the realm of alternative investments has become increasingly complex. It is, therefore, crucial to utilize unconventional methods within the portfolio construction process for evaluating managers that go beyond popular measures of performance analysis, such as Internal Rate of Return (IRR), Total Value to Paid-In (TVPI), Residual Value to Paid-In (RVPI), and Distributed to Paid-In (DPI). In this article, we shed light on the importance of gaining a more comprehensive understanding of alternative investment fund returns by examining factors that are often overlooked.

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While conventional measures do, of course, offer reliable insights into manager performance, they fail to tell a holistic story on a standalone basis. By incorporating ancillary metrics, investors can gain a deeper understanding of the true value drivers within their alternative allocations. In the upcoming sections, we will carefully analyze these factors considering the two primary pillars, each of which comprises two sub-factors.

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Opportunity cost

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A topic that merits significant attention when evaluating alternatives is the opportunity cost of capital. This measure considers the potential return that could have been achieved compared to other available investment opportunities.

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Time effect from commitment to deployment

It is simple and yet critical to recognize that the date of commitment often differs meaningfully from the date of initial capital deployment. This disparity must be treated when calculating performance measures.

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By incorporating this gap, we can make more accurate and informed investment decisions. Failing to account for this time difference may result in a misleading disruption of certain metrics, as it incorrectly reduces the duration of committed capital.

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Denominator effect from committed but uncalled capital

Another oft-overlooked aspect appears in the form of uncalled capital. When investors commit capital to alternative investments, relatively little is usually called by the General Partner (GP) in the early fund life. In fact, more often than not, a portion of the committed capital is never called (on average approximately 10-20% depending on strategy, GP, etc.). These non-utilized portions of capital commitments represent a potential resource that could otherwise be strategically deployed to seize lucrative investment opportunities. Assessing the amount and timing of uncalled capital is essential for gaining an unbiased perspective on returns relative to the committed capital.

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In theory, Limited Partners (LPs) have the option to invest any such ‘encumbered’ funds into short-term investments until a prospective capital call occurs, but not all LPs are willing or able to pursue a liquidity-management strategy.

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Expanding the Horizon of Evaluation

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ROCC & MOCC

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To address the aforementioned considerations, the inclusion of metrics such as MOCC (Multiple on Committed Capital) and ROCC (Return on Committed Capital) within the portfolio engineering process can provide valuable insights when identifying the best performers or selecting the most suitable investments for our portfolio.

Clarifying the importance of ROCC & MOCC

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ROCC offers a different approach when compared with a traditional IRR calculation. By incorporating the opportunity cost of uncalled capital and factoring in the potential discrepancies between commitment and deployment of capital, we can create a more comprehensive evaluation. This approach may lead to a lower performance KPI, but it presents a more realistic representation of an investment's performance. The calculation resembles an IRR, but the total uncalled (committed) capital is added at the beginning and at the end of the series of cash flows. This enables an analyst to account for both, time, and cost of parking capital.

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MOCC, which measures the multiple achieved on committed capital, provides an additional key performance indicator (KPI) to the more widely recognized 'multiples' commonly used in the industry, such as MOIC and TVPI. The multiple on committed capital is calculated by considering the realized gains, unrealized gains, and equalization interest to the capital commitment. Of course, the denominator in this ratio will be higher relative to traditional MOIC metrics as we use the committed capital instead of paid-in capital, which could be significantly lower, thus resulting in a lower multiple.

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ROCC and MOCC are defined by the following equations:

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Added Value from Incorporation of Ancillary Metrics

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Perceiving the influences

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By incorporating both ROCC and MOCC into a manager selection process, alternatives investors can enhance their understanding of performance and make more informed decisions regarding their portfolio investments. Similarly, incorporating an SL into performance measurement analysis provides another perspective by considering potential differences that investors may notice between conventional and ancillary KPIs.

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Let us briefly explore the impact of an SL on the internal rate of return (IRR). An SL is a liquidity facility secured against LPs’ commitments to execute fund investments relatively early in a fund’s life cycle without the need to make immediate capital calls. This arrangement brings a range of benefits for GPs and LPs, including the flexibility to execute deals with no frequency and small capital calls. However, to fully comprehend the implications, and to grasp performance gauges, an extra understanding of this tool is essential.

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In the examples below, we provide a visual representation showing two cases of funds using SLs with various levels of borrowed funds and extensions. To illustrate the effect of an extreme scenario more clearly, we have exaggerated the differences in the representation, for both the amount of borrowed funds and the duration (using simulated data). The fund with a significant and prolonged SL strategy (Fund A v1), shows an improved IRR during the early and midlife stages, in contrast to the typical J-curve pattern seen in the second example (Fund A v2) for a light and moderate use of the SL facility.

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This aspect can be captured using the ROCC framework by considering the number of days from the commitment date and the uncalled capital. In the case of the use of the MOCC, unlike TVPI (Total Value to Paid-In) or other standard multiple-based KPIs, MOCC considers the uncalled capital, resulting in a more accurate depiction.

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EXHIBIT I: Example of subscription line influence on IRRs

_{For illustrative purposes only.}

_{Source: Klarphos as of August 31, 2023.}

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Means of Subtle Embedding into Investment Analysis

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How should we incorporate alternative measures into our analysis?

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In the chart below, we present the Mosaic approach as a pie chart, where we assign chosen relevance (weights) to each metric for a specific investment. This discretionary use of performance measures enables us to address unique features that are specific to each investment. By assigning weights to these methods, we can compare and generate ratings, thus gaining potentially unique insights into various funds. Please note that these weights vary across all investment analyses and are merely illustrative in this case.

EXHIBIT II: Mosaic approach example (in %)

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_{Source: Klarphos as of August 31, 2023. 1) Credit worthiness of LPs; 2) Subscription line.}

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Continuing with Exhibit III, which depicts a real example renamed for article purposes, we can present a simplified deck that lists a blend of metrics for Fund A and Fund B. Upon initial observation, both Fund A and Fund B exhibit similarities in various key aspects, such as their commitment dates and commitment amounts, their adherence to alternative investment strategies, and their respective vintages.

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However, upon closer scrutiny, notable variations become apparent in the percentage of uncalled capital across the two funds. These divergences significantly contribute to the variations observed in ROCC and MOCC metrics between the funds. The disparities are substantial, specifically the fund with a higher percentage of uncalled capital, standing at 69% (a 48% superior), leads to a 700-basis point spread in the ROCC when compared against the IRR. When examining the TVPI, there is a discrepancy of 0.76€ in the return per invested € compared to the MOCC.

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EXHIBIT III: Performance comparison

_{(Klarphos Q1-2023 Private Debt Funds re-named)}

_{For illustrative purposes only.}

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_{Source: Klarphos as of March 31, 2023.}

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Navigating Potential Challenges: What Lies Ahead

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It’s not all smooth sailing; there are some drawbacks worth considering

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As discussed earlier, we examined the merits of including additional metrics in the analysis. However, challenges may persist. One such difficulty is determining if the respective funds within the analysis are engaged in recycling capital. We define recycling as reinvesting proceeds from actual investments within the fund.

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This factor can significantly impact the figures and lead to misleading conclusions when utilizing ROCC and MOCC as gauges.

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In the MOCC figures of the below Exhibit IV, Fund 1 (with recycling) outperforms Fund 2 (without recycling). The effect is due to a higher numerator (earnings) that includes additional earnings from recycling on Fund 1. Fund 2 will not benefit from incremental investments while the denominator (the committed capital) remains the same for both.

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However, if we calculate TVPI, we will see that the manager of Fund 2 (without reinvesting) outperforms Fund 1 (with reinvesting). The difference is explained by the incrementally invested capital that will affect Fund 1.

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EXHIBIT IV: Capital recycling effect

_{For illustrative purposes only.}

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_{Source: Klarphos as of August 31, 2023.}

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One more challenge to reckon with is the elapsed time. Time is critical when you evaluate investments based on multiples. A 2.5x MOCC is not the same if the time elapsed is 10y or 5y; the respective IRRs will be 11% and 26%, as you can see in Exhibit V below. We must consider the following aspects when using ROCC:

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• The ROCC assumes that the entire investment is made up front, but this is not always the case. Most private markets work with sequential deployments.
• The ROCC shares the same reinvesting assumption as the IRR. The ability to reinvest cash flows at the same rate can vary, significantly impacting the actual return experienced by investors. This is usually the case, because institutional investors maintain a vast majority of the unfunded commitment of illiquid investments in liquid investments with low returns.

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EXHIBIT V: Time impact on IRR vs MOCC

_{For illustrative purposes only.}

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_{Source: Klarphos as of August 31, 2023.}

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A Holistic View for Private Markets

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Main takeaways

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To enhance the quality of performance evaluation within illiquid assets, it is essential to adopt a holistic view. It is crucial to understand how GPs manage their unfunded commitments. LPs should consider a broader range of KPIs when making investment decisions such as ROCC and MOCC, as we previously mentioned using the conglomerate of KPIs and giving the appropriate relevance.

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Furthermore, they should look beyond numbers and consider other features that could be embedded in a fund such as subscription lines, capital recycling, strategy fundamentals or the investment environment when the portfolio was invested and divested. While the analytical process may appear simple, it involves a remarkably high degree of complexity.

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Important Information

This document is informative purposes only. It does not constitute research, investment advice nor solicitation to invest in any investment product or service that Klarphos offers or may offer in the future in any jurisdiction. The information contained herein is based on projections, estimates and/or other financial data and has been prepared internally by Klarphos. Opinions expressed therein are current opinions as of the date of this document only and are subject to change at any time without notice.

No representations are made as to the accuracy of the observations, assumptions and projections. No subscriptions to any Klarphos products are possible based solely on this document. Any investment decisions should be made in accordance with the legal documentation of a fund such as its offering memorandum.

Klarphos is not entitled to provide any tax or legal advice.

Past performance is not indicative of future returns. There can be no assurance that the strategy objectives will be realized or that the strategy will not experience losses. Target returns are hypothetical and are neither guarantees nor predictions of future performance. There can be no assurance that the target returns will be achieved.

Klarphos is an Asset Manager specialized in customized portfolio solutions and advisory services for institutional clients based in Luxembourg. Klarphos concentrates its asset management on Alternative Investments and also provides advisory services for strategic asset allocation and ALM optimization. The asset manager employs an international team of specialists and is regulated by the Luxembourg financial regulator CSSF as an Alternative Investment Fund Manager (AIFM).