The fund return model is a financial model in financial modeling. It’s the difference in value between the start-up capital used to launch a business with no profits and when it makes its first profit.
The fund return model is used in Private equity, venture capital, and other investments. The risk of investing in start-ups is that they may fail due to lack of market demand or changes in the way that consumers use their product/service. The risk with investing profits into new businesses is that they may fail or not be able to scale their business or increase sales enough so they can turn a profit without taking on more debt than what was initially invested by the investor.
When a business is first created, it’s start-up capital is used on things such as office space, wages for employees that work on creating the product/service, and any inventory that the company may have. Investors believe that by providing start-up capital to new businesses they can help shape what the new business will become based on who is hired, how the product/service is marketed to customers, or other factors. The future profitability of these businesses are unknown at this point in time. At its first profit the business now has an amount of revenue coming in from selling their product/service. This has changed from when they were spending money without making any revenue.
Here are the two main concepts in this model:
Fund – This is the amount of money that’s invested into the business at the start of the investment.
Payout – This is how much money comes out to equity investors after a certain number of years. Typically, this is a number that’s given to a business to help them grow. Investors expect a return on the amount of money they put into the business.
There are two main types of payouts: Exit payouts and dividend payouts. The exit payout is also known as the cash-on-cash return or internal rate of return that investors look for when investing into businesses. It’s the profit that investors make from their investments after all costs have been accounted for. It gives investors a way to compare how profitable their investments have been based on what they have put in and how much they have made out of those investments. The dividend payout is the amount of money that investors get paid each year to help them grow their equity funds.
The formula for calculating the fund return model for start ups is:
Fund Return = Start-up Capital x (Profits – Start-up Capital) / (Interest + Distributions)
Start-up capital – This is the amount of money that’s used to launch a new business. Investors may use funds from personal savings, friends, credit cards, or other ways to help launch their new businesses. It’s basically money that’s invested by investors at the start of a new business venture.
The interest + distributions are how much cash is returned to investors after all costs have been paid. For example, if the company was able to make 20X their start-up capital after 5 years, investors would receive 80% of what they invested back. It’s also how investors calculate how profitable their investments are.
Features of a Good Fund Return Model
There are a number of factors to consider when evaluating your returns model and if it’s designed to meet the needs of the fund and your investors. A good returns model should meet both the need of the funds as well as that of investors. The fund should also be transparent in its operations and be time saving as well. Other key attributes of a good funds returns model identified by PwC are:
- It should contain all returns metrics as well as KPI’s for various classes of investors.
- The model should be transparent enough to such that key information such as forecast cash flows for the fund, investing requirements, capital calls, investor distributions etc can be easily determined.
- A clear distinction between both realized and unrealized historic returns.
- Align with historical data from your systems, to allow for a meaningful comparison of actual versus forecast results and to provide robust returns calculations over the life of the fund.
- A clear statement on the use of any type of leverage and related covenants both in the current time period and for future periods.
- Clear summary of market dynamics i.e., indicating the key drivers of growth and fund performance with specific references in terms of investments, regions, asset class etc.
- Forecasts based on “value drivers” including sensitivity and scenario analysis to varying outputs in order to better understand key risks of fund performance.
- The model should embrace flexibility. Without adequate flexibility, it wont be replicable when a replication is required across other funds. flexibility helps ensure appropriate variables can be modified for differing, more complex structures and geographic locations and regulations.
- A good funds returns model should comply with stated performance standards e.g., Global Investment Performance Standards “GIPS”, or with other disclosed regulations a fund manager is subject to.
Mutual Fund Return Models
Fund models generally refer to how a fund’s performance is measured. Since there are so many types of funds, there are also many different fund models. One of the most common example is the mutual fund. The mutual fund is the net asset value (NAV) per share or unit price. It provides an easy way to compare different funds because it takes into account both how much money was invested in the fund at its inception, and how much it has since increased or decreased based on market conditions. The NAV per share reflects all of the buying and selling activity over a given time period after adjusting for investment income or losses.
Investors’ annualized returns reflect the historical performance of mutual funds as measured by their total distributions (cash and/or other items such as securities, dividends, or interest) over a given period. The calculation takes into account both the positive and negative distributions (or distributions minus redemption). These numbers are, therefore, not indicative of future returns.
If you are comparing mutual funds, it is important to know how each fund calculates its rate of return. Some funds take large amounts of money for themselves, sometimes more than 1 percent per year, which can significantly reduce an investor’s annualized rate of return. There are four types of rates that investors should be aware of: net assets value (NAV), cash assets value (CAV), modified cash assets value (MCAV) and character income yield (CIY). Be sure to consider these calculations when comparing fund returns.
Another way that mutual funds can be measured is by risk-adjusted return, which takes into account how volatile a fund has been over a given period. Since some funds are more volatile than others, risk-adjusted return allows investors to compare all types of funds by standardizing the comparison on an apples-to-apples basis as compared to the average U.S. stock market index (such as the S&P 500). Risk-adjusted return is calculated by taking the geometric mean of a series of returns based on expected volatility and measuring its ability to generate excess returns relative to a risk-free alternative (such as short term T Bills).
The Sharpe Ratio is a risk adjusted return measure that was developed by Nobel prize-winning economist William F. Sharpe in 1966. It is intended to compare the returns of a security or a portfolio with the level of risk associated with it. The ratio is calculated by subtracting the risk free rate (such as T bills) from the fund’s return and dividing this result by the standard deviation of the fund’s returns over the same period. The higher the Sharpe ratio, the better!
There are several different types of market indices, each with their own methodology, standardization and time periods. Each type of market index is used to measure performance, and also to compare portfolio performance with other types of portfolios or the broad market. There are several different standards for calculating market indices. The normalizing factor (also called the base period) is used to convert back and forth between any of these standards so that they all mathematically equate to each other – this is what you should verify when comparing portfolio performance with other types of portfolios or the broad market.
After you’ve compared different funds and calculated rates and ratios, it’s important to look at how those numbers compare over time. This can help you track your investments, as well as give you an idea of how securities may perform in the future. The key to understanding your fund performance is being able to compare it with other investments that have similar risk and return objectives.
Another way to evaluate a fund’s performance is by using a financial ratio called beta. Beta measures a security’s volatility relative to the market as a whole. The use of beta allows investors to compare securities that have different risk and return characteristics by comparing their betas. Beta is calculated by taking the covariance of a fund’s returns with the return of an index, such as the S&P 500, and dividing it by the correlation coefficient of the same returns with that same index.
The world of financial markets is complex and difficult to understand. The bottom line is that it’s important to be informed about where you invest your money, whether or not you choose to engage a professional adviser would ultimately depend on a honest assessment of ones own research abilities.
