Hedge Fund Valuation in Connection with Equitable Distribution

Hedge Fund Structure

In order to understand the way a hedge fund operates, and ultimately to determine the value of the hedge fund management entities, it is important to understand the structure of a typical hedge fund. The term “hedge fund,” broadly defined, refers to a structure of at least three companies: (A) the Management Company (or investment manager), which manages investors' assets together with (B) the General Partner (or GP), and (C) the Fund, itself. There may also be one or more offshore funds for non-U.S.-based investors or U.S. tax exempt investors, and the hedge fund may also have separate “managed accounts” for large investors.

In a typical hedge fund, capital is raised from accredited investors, as defined in the Securities Act of 1933. These investors usually have similar investment objectives, and the Fund's investment objectives, along with the types of securities in which the Fund will invest, should be set forth in the Fund's offering documents (i.e., a Confidential Private Placement Memorandum and/or Subscription Agreement).

Provided the prospective investor agrees with a fund's investment objectives, as set forth in the agreements mentioned above, the investor will subscribe to the Fund and commit a certain amount of capital to the Fund. A capital account is then created for each investor, in order to track the performance of each investor's capital (i.e., for bookkeeping and fee-charging purposes), and the capital of several investors is pooled into a Fund, which for a typical domestic fund is organized as a Limited Partnership (or LP). The hedge fund's General Partner also has an interest, and therefore, a capital account, in the LP. The LP typically enters into an investment management agreement with the Management Company, which defines the roles of the Management Company and the GP, and gives the Management Company the authority to manage the Fund's assets on a discretionary basis.

If the subject company hedge fund is attempting to attract offshore or tax-exempt investors, it may also establish an offshore fund. An offshore fund may give rise to deferred fees, which present additional issues for a valuator.

A hedge fund's principal or principals typically keep a large portion of their own net worth in the Fund itself to assure investors that they have confidence in their ability to manage the Fund's assets effectively. The fair market value of a principal's direct investment in the Fund(s) will be reflected in monthly capital account statements issued by the hedge fund's third party administrator. The value of the principal's capital account is separate from the value of the operations of the hedge fund.

Management of the Fund and Structure of Fees Charged

The Management Company and the GP manage the assets pooled in the Fund. The Management Company's staff makes investment decisions regarding the allocation of the Fund's assets. In many hedge-fund structures, control over the day-to-day operations is concentrated among one, or at most, a few investment professionals. In other words, the hedge fund's founder(s)/principal(s) make most of the investment decisions.

The Management Company charges investors a base management fee of 1% to 2% of AUM. This base management fee is charged on the amount of capital in each investor's capital account, and will be charged regardless of whether or not the capital account appreciates in value.

In addition, as defined in the hedge fund's offering documents, the GP of the Fund is entitled to receive a performance fee of (usually) up to 20% of the appreciation in an investor's capital account in a given year, subject to high watermark provisions. In many hedge fund structures, the sole role of the GP is to collect the incentive fee income.

A “high watermark” refers to the highest value of the assets that each partner's capital account has reached, exclusive of additional capital contributions. The following is a simple example of a high watermark: Suppose I contributed $100 of capital to a fund. My beginning capital account balance for the year would be $100. During Year 1, my capital account grows to $120, after base management fees are charged. The GP is entitled to receive a 20% incentive or performance fee, based on the $20 appreciation in the account in Year 1. Thus, in Year 1, the GP is paid an incentive fee of $4 ($20 appreciation x 20%), and my beginning capital for Year 2 is now $116. Now, let us assume that in Year 2, as a result of poor market performance and bad investment decisions, the value of my capital account at the end of Year 2 fell to $105. In Year 2, I will still be charged the base management fee (charged regardless of performance), but I will not pay an incentive fee to the GP, because my return on investment was negative in Year 2. Thus, the high watermark for my investment is $116, and as a result, my capital account will not be charged incentive fees until the value of my account eclipses the $116 “high watermark” set in Year 1. The above example illustrates the unpredictability, volatility and high risk associated with the incentive fee income stream.

Valuation of a Hedge Fund

In valuing a hedge fund, an appraiser should consider the size and structure of the hedge fund, in terms of employees, number of funds managed, its level of assets under management, how fees are charged to investors, and the reliance on a single individual or a few individuals to make investment decisions. It is important to examine and analyze trends in the subject hedge fund's AUM, management fees, incentive fees and compensation paid to the hedge fund's principals and employees. Also, be sure to consider the current state of the U.S. and global economies and the securities markets.

The first item a business appraiser should look at is a hedge fund's total AUM. Check that the reported management fees make sense, given the level of AUM over the period reviewed.

The appraiser should then examine the Management Company's profit and loss statement, specifically, the compensation paid from the management company. Is the Management Company paying base salaries to employees as well as bonus compensation? The issue of compensation paid to employees is an integral component in the valuation of a hedge fund, because bonus compensation should be somewhat in-line with the hedge fund's performance. In other words, if a hedge fund has had low employee turnover and has not received incentive fees in the last two years due to a bad market and/or poor management, is it still paying a high amount of bonus compensation to employees? If this is so, you should ask why.

Typically, it is the Management Company that pays all overhead expenses, as well as all other expenses associated with running the business, including, sometimes, bonus compensation to employees, depending on the size of the fund. Each hedge fund compensates its employees differently. It is important to understand a hedge fund's compensation structure prior to developing valuation conclusions.

The appraiser should bifurcate the hedge fund's income streams between: 1) management fees; and 2) incentive fees. The proper method of valuing a hedge fund's operations is to match overhead expenses and base salaries with the management fee income stream. The bonus compensation paid or allocated to employees should be matched against the incentive fee income stream.

When valuing a hedge fund, the appraiser should examine as long a history as is practicable.

Management Fee Income Stream

As mentioned previously, the hedge fund's management fee income stream is based on a percentage of the Fund's AUM. This makes the management fee income stream more predictable than the incentive fee income stream. After properly matching the expenses against the management fee income stream, the excess of normalized management fees over normalized expenses (i.e., normalized management fee earnings/cash flow) should be capitalized at a rate lower than the related capitalization rate utilized in the valuation of the incentive fee income stream, as discussed below.

With respect to the determination of the proper capitalization rate to apply to the management fee earnings stream, an appraiser should consider factors such as: its vintage (i.e., when founded), its track record of excess management fee earnings, its reputation in the industry, its founders'/principals' history in the industry and its size, among other factors.

Incentive Fee Income Stream

The incentive fee income stream can be volatile and unpredictable. An incentive ' or performance ' fee is only earned when the investors' capital in the Fund appreciates. For a GP to continue to earn incentive fees, the hedge fund must continue to produce positive gains for each investor. Like the financial markets themselves, this income stream is difficult to forecast.

Analyzing the hedge fund's performance fee earnings stream over a longer time period serves to smooth the incentive fee income stream, thus taking into account a portion of the heightened level of risk associated with the incentive fee income stream. In order for there to be value to a hedge fund's incentive fee earnings stream, there must be a track record of positive performance fees (net of bonus compensation) over the years analyzed.

In determining the proper capitalization rate to apply to the hedge fund's normalized incentive fee earnings, consider all of the factors involved in determining the capitalization rate of the management fee earnings stream, and then consider the additional risk inherent in the incentive fee earnings stream due to its volatility.

Alternative Valuation Methods

One of the ways a valuator can value a business in a certain industry is to look at valuation multiples (e.g., price-to-revenue, price-to-EBITDA (earnings before interest, taxes, depreciation, and amortization), price-to-AUM, etc.) utilized in the valuation of similar companies in the same industry. This is called the Market Approach. For instance, when valuing a privately-held accounting firm, the general valuation rule of thumb is to apply a multiple of 1.0 to 1.25 times the subject company's annual revenue. However, there is no hard-and-fast rule in valuing a hedge fund, given the high level of industry volatility.

Berkshire Capital Securities, LLC, publishes annually a study called the Investment Management Industry Review. This publication contains detailed discussions of transactions within several segments of the investment management industry. One section of the Investment Management Industry Review includes the discussion of transactions of hedge funds and private equity management companies. Over the past 10 years, we have seen average AUM multiples ranging from 0.6% of AUM on the low end to 6.3% of AUM on the high end. The fluctuations in valuation multiples highlights the importance of proper due diligence and taking into account all of the factors specific to each subject hedge fund when performing a valuation.

Summary

When faced with the task of valuing a hedge fund, a valuator should be sure to examine all of the factors: its structure, its history, its profitability, its management fee earnings, its incentive fee earnings, its compensation (base and bonus) paid to employees, its reputation, and its key personnel, among others. A hedge fund principal may have interests in the Fund through the Management Company and the General Partner, but he/she may also have a significant direct interest in the Fund. The Emergency Economic Stabilization Act of 2008 limited the ability of hedge funds and private equity managers to defer fees generated offshore, but a valuator should still ask about any deferred compensation arrangements which may have existed prior to the law taking effect.

In most cases, a hedge fund consists of a Management Company, a General Partner, and one or more (domestic or offshore) Funds. In addition to the value of the operations of the hedge fund (i.e., in connection with its ability to generate positive management fee and incentive fee earnings over a period of time), a hedge fund principal may also have a significant level of assets invested within the Fund itself.

Conclusion

There is no “rule of thumb” with respect to the valuation of a hedge fund interest. Hedge funds are complex entities with complex people using complex investment strategies; therefore the valuation of a hedge fund is complex, by nature.

Steven Cusumano is a senior associate in the forensic accounting and business valuation firm of Klein Liebman & Gresen, LLC (KLG). He assists attorneys, judges, accountants, and business owners in forensic accounting, business valuation and litigation support matters. Contact him at [email protected]. If you would like to find out more about KLG, please visit their website at www.goKLG.com.

Over the past two decades, notwithstanding the recent economic downturn, the alternative investment industry has grown at a rapid pace, in terms of dollars flowing into the funds from investors, and the overall number of funds. Many former portfolio managers and managing directors of large investment banks have left their former institutions to establish hedge funds and other alternative investment outfits. These professionals are lured by lower levels of regulation and the ability to earn higher levels of income at an alternative investment firm than at a traditional investment bank.

Hedge funds now comprise a large portion of the alternative investment industry, and in connection with equitable distribution statutes, the valuation of a hedge fund management company and General Partner are becoming more important. Determining the proper value to ascribe to these interests is complex, and as will be discussed below, matrimonial attorneys should be aware that the value of an individual's interest in a hedge fund is often greater than just the value of his or her capital account. Additionally, given the turbulent economy, and specifically the volatility in the financial markets over the last three-plus years, hedge fund valuation presents several challenges in the field of business valuation for the purposes of equitable distribution.

Valuing an individual's interest in a hedge fund management company and/or general partnership is different from valuing an interest in an operating company, a professional corporation, or even an investment management company. The main challenge for valuators is the fact that hedge fund managers earn income two ways: from base management fees (typically 1% to 2% of assets under management, or AUM) and incentive fees, which are based on the performance of the assets in the fund (typically around 10% to 20% of the appreciation, subject to certain hurdle rates and a high watermark).

Hedge Fund Structure

In order to understand the way a hedge fund operates, and ultimately to determine the value of the hedge fund management entities, it is important to understand the structure of a typical hedge fund. The term “hedge fund,” broadly defined, refers to a structure of at least three companies: (A) the Management Company (or investment manager), which manages investors' assets together with (B) the General Partner (or GP), and (C) the Fund, itself. There may also be one or more offshore funds for non-U.S.-based investors or U.S. tax exempt investors, and the hedge fund may also have separate “managed accounts” for large investors.

In a typical hedge fund, capital is raised from accredited investors, as defined in the Securities Act of 1933. These investors usually have similar investment objectives, and the Fund's investment objectives, along with the types of securities in which the Fund will invest, should be set forth in the Fund's offering documents (i.e., a Confidential Private Placement Memorandum and/or Subscription Agreement).

Provided the prospective investor agrees with a fund's investment objectives, as set forth in the agreements mentioned above, the investor will subscribe to the Fund and commit a certain amount of capital to the Fund. A capital account is then created for each investor, in order to track the performance of each investor's capital (i.e., for bookkeeping and fee-charging purposes), and the capital of several investors is pooled into a Fund, which for a typical domestic fund is organized as a Limited Partnership (or LP). The hedge fund's General Partner also has an interest, and therefore, a capital account, in the LP. The LP typically enters into an investment management agreement with the Management Company, which defines the roles of the Management Company and the GP, and gives the Management Company the authority to manage the Fund's assets on a discretionary basis.

If the subject company hedge fund is attempting to attract offshore or tax-exempt investors, it may also establish an offshore fund. An offshore fund may give rise to deferred fees, which present additional issues for a valuator.

A hedge fund's principal or principals typically keep a large portion of their own net worth in the Fund itself to assure investors that they have confidence in their ability to manage the Fund's assets effectively. The fair market value of a principal's direct investment in the Fund(s) will be reflected in monthly capital account statements issued by the hedge fund's third party administrator. The value of the principal's capital account is separate from the value of the operations of the hedge fund.

Management of the Fund and Structure of Fees Charged

The Management Company and the GP manage the assets pooled in the Fund. The Management Company's staff makes investment decisions regarding the allocation of the Fund's assets. In many hedge-fund structures, control over the day-to-day operations is concentrated among one, or at most, a few investment professionals. In other words, the hedge fund's founder(s)/principal(s) make most of the investment decisions.

The Management Company charges investors a base management fee of 1% to 2% of AUM. This base management fee is charged on the amount of capital in each investor's capital account, and will be charged regardless of whether or not the capital account appreciates in value.

In addition, as defined in the hedge fund's offering documents, the GP of the Fund is entitled to receive a performance fee of (usually) up to 20% of the appreciation in an investor's capital account in a given year, subject to high watermark provisions. In many hedge fund structures, the sole role of the GP is to collect the incentive fee income.

A “high watermark” refers to the highest value of the assets that each partner's capital account has reached, exclusive of additional capital contributions. The following is a simple example of a high watermark: Suppose I contributed $100 of capital to a fund. My beginning capital account balance for the year would be $100. During Year 1, my capital account grows to $120, after base management fees are charged. The GP is entitled to receive a 20% incentive or performance fee, based on the $20 appreciation in the account in Year 1. Thus, in Year 1, the GP is paid an incentive fee of $4 ($20 appreciation x 20%), and my beginning capital for Year 2 is now $116. Now, let us assume that in Year 2, as a result of poor market performance and bad investment decisions, the value of my capital account at the end of Year 2 fell to $105. In Year 2, I will still be charged the base management fee (charged regardless of performance), but I will not pay an incentive fee to the GP, because my return on investment was negative in Year 2. Thus, the high watermark for my investment is $116, and as a result, my capital account will not be charged incentive fees until the value of my account eclipses the $116 “high watermark” set in Year 1. The above example illustrates the unpredictability, volatility and high risk associated with the incentive fee income stream.

Valuation of a Hedge Fund

In valuing a hedge fund, an appraiser should consider the size and structure of the hedge fund, in terms of employees, number of funds managed, its level of assets under management, how fees are charged to investors, and the reliance on a single individual or a few individuals to make investment decisions. It is important to examine and analyze trends in the subject hedge fund's AUM, management fees, incentive fees and compensation paid to the hedge fund's principals and employees. Also, be sure to consider the current state of the U.S. and global economies and the securities markets.

The first item a business appraiser should look at is a hedge fund's total AUM. Check that the reported management fees make sense, given the level of AUM over the period reviewed.

The appraiser should then examine the Management Company's profit and loss statement, specifically, the compensation paid from the management company. Is the Management Company paying base salaries to employees as well as bonus compensation? The issue of compensation paid to employees is an integral component in the valuation of a hedge fund, because bonus compensation should be somewhat in-line with the hedge fund's performance. In other words, if a hedge fund has had low employee turnover and has not received incentive fees in the last two years due to a bad market and/or poor management, is it still paying a high amount of bonus compensation to employees? If this is so, you should ask why.

Typically, it is the Management Company that pays all overhead expenses, as well as all other expenses associated with running the business, including, sometimes, bonus compensation to employees, depending on the size of the fund. Each hedge fund compensates its employees differently. It is important to understand a hedge fund's compensation structure prior to developing valuation conclusions.

The appraiser should bifurcate the hedge fund's income streams between: 1) management fees; and 2) incentive fees. The proper method of valuing a hedge fund's operations is to match overhead expenses and base salaries with the management fee income stream. The bonus compensation paid or allocated to employees should be matched against the incentive fee income stream.

When valuing a hedge fund, the appraiser should examine as long a history as is practicable.

Management Fee Income Stream

As mentioned previously, the hedge fund's management fee income stream is based on a percentage of the Fund's AUM. This makes the management fee income stream more predictable than the incentive fee income stream. After properly matching the expenses against the management fee income stream, the excess of normalized management fees over normalized expenses (i.e., normalized management fee earnings/cash flow) should be capitalized at a rate lower than the related capitalization rate utilized in the valuation of the incentive fee income stream, as discussed below.

With respect to the determination of the proper capitalization rate to apply to the management fee earnings stream, an appraiser should consider factors such as: its vintage (i.e., when founded), its track record of excess management fee earnings, its reputation in the industry, its founders'/principals' history in the industry and its size, among other factors.

Incentive Fee Income Stream

The incentive fee income stream can be volatile and unpredictable. An incentive ' or performance ' fee is only earned when the investors' capital in the Fund appreciates. For a GP to continue to earn incentive fees, the hedge fund must continue to produce positive gains for each investor. Like the financial markets themselves, this income stream is difficult to forecast.

Analyzing the hedge fund's performance fee earnings stream over a longer time period serves to smooth the incentive fee income stream, thus taking into account a portion of the heightened level of risk associated with the incentive fee income stream. In order for there to be value to a hedge fund's incentive fee earnings stream, there must be a track record of positive performance fees (net of bonus compensation) over the years analyzed.

In determining the proper capitalization rate to apply to the hedge fund's normalized incentive fee earnings, consider all of the factors involved in determining the capitalization rate of the management fee earnings stream, and then consider the additional risk inherent in the incentive fee earnings stream due to its volatility.

Alternative Valuation Methods

One of the ways a valuator can value a business in a certain industry is to look at valuation multiples (e.g., price-to-revenue, price-to-EBITDA (earnings before interest, taxes, depreciation, and amortization), price-to-AUM, etc.) utilized in the valuation of similar companies in the same industry. This is called the Market Approach. For instance, when valuing a privately-held accounting firm, the general valuation rule of thumb is to apply a multiple of 1.0 to 1.25 times the subject company's annual revenue. However, there is no hard-and-fast rule in valuing a hedge fund, given the high level of industry volatility.

Berkshire Capital Securities, LLC, publishes annually a study called the Investment Management Industry Review. This publication contains detailed discussions of transactions within several segments of the investment management industry. One section of the Investment Management Industry Review includes the discussion of transactions of hedge funds and private equity management companies. Over the past 10 years, we have seen average AUM multiples ranging from 0.6% of AUM on the low end to 6.3% of AUM on the high end. The fluctuations in valuation multiples highlights the importance of proper due diligence and taking into account all of the factors specific to each subject hedge fund when performing a valuation.

Summary

When faced with the task of valuing a hedge fund, a valuator should be sure to examine all of the factors: its structure, its history, its profitability, its management fee earnings, its incentive fee earnings, its compensation (base and bonus) paid to employees, its reputation, and its key personnel, among others. A hedge fund principal may have interests in the Fund through the Management Company and the General Partner, but he/she may also have a significant direct interest in the Fund. The Emergency Economic Stabilization Act of 2008 limited the ability of hedge funds and private equity managers to defer fees generated offshore, but a valuator should still ask about any deferred compensation arrangements which may have existed prior to the law taking effect.

In most cases, a hedge fund consists of a Management Company, a General Partner, and one or more (domestic or offshore) Funds. In addition to the value of the operations of the hedge fund (i.e., in connection with its ability to generate positive management fee and incentive fee earnings over a period of time), a hedge fund principal may also have a significant level of assets invested within the Fund itself.

Conclusion

There is no “rule of thumb” with respect to the valuation of a hedge fund interest. Hedge funds are complex entities with complex people using complex investment strategies; therefore the valuation of a hedge fund is complex, by nature.

Steven Cusumano is a senior associate in the forensic accounting and business valuation firm of Klein Liebman & Gresen, LLC (KLG). He assists attorneys, judges, accountants, and business owners in forensic accounting, business valuation and litigation support matters. Contact him at [email protected]. If you would like to find out more about KLG, please visit their website at www.goKLG.com.