Equitable Distribution and Hedge Funds

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]. KLG website: www.goKLG.com. This article also appeared in The Matrimonial Strategist, an ALM sister publication of this newsletter.

As discussed last month, valuing a divorcing party's interest in a hedge fund management company and/or general partnership differs from valuing an interest in a professional corporation, an operating company or an investment management company. This is primarily because hedge fund managers earn income two ways: from base management fees and from incentive fees.

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 assets under management (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]. KLG website: www.goKLG.com. This article also appeared in The Matrimonial Strategist, an ALM sister publication of this newsletter.