JULY 14, 2013
The Market Environment
The amount of money managed by hedge funds has seen a steady increase from the drawdown experienced in the aftermath of the collapses of Lehman Brothers and Bear Sterns. At the end of 2012, excluding fund of funds assets, the industry had nearly $1.8 trillion in assets under management (AUM). The valuation of hedge funds and other alternative asset managers remains a difficult task, despite the growth in the industry, and notable mergers and acquisitions (M&A) in the sector. Some of the obstacles include the fact that the number of publicly traded alternative managers is relatively small compared to traditional money managers, with only a handful of funds listed on exchanges. While valuing traditional asset managers can also present a challenge, the task is greatly complicated by the fact that hedge fund revenues are by definition more volatile; unlike the steady revenue streams in the traditional money management business, as discussed below, the lion’s share of a hedge fund’s value is derived from the option-like potential of performance fees. There are several drivers for future M&A activity in the hedge fund space that make the topic of hedge fund valuation important. First is
the regulatory environment; SEC registration requirements are increasing compliance and infrastructure costs beyond what some smaller firms can afford, forcing them to sell to larger firms. The Volker rule, which restricts hedge fund ownership by depository banks, has also forced many large banking institutions to divest themselves of their internal funds. This was illustrated by the announcement in December 2012 that Citigroup would spin off its hedge fund unit as it prepares to comply with the rule which takes effect in 2014. The second driver of hedge fund M&A is the tax climate. Proposed changes in the carried interest tax and the enterprise value tax will lead owners to consider selling and taking advantage of the current more favorable capital gains rates. In the case of the carried interest tax, the proposals currently before Congress would treat carried interest as ordinary income, taxed at 35%-39.6% instead of the lower capital gains tax of 15%-20%. The treatment of profits from the sale of investment management partnerships, such as private equity firms and hedge funds, would also face a similar revision in their tax treatment if the current proposals pass. For some hedge fund managers that have built up their funds and are looking to dilute their stakes, now seems an opportune time, a reality reflected in the recent purchase by The Texas Teacher Retirement System of a stake in Bridgewater Associates, the world’s largest hedge fund. The move is in large part a result of Bridgewater’s plan to dilute the stakes held by its founder Ray Dalio. The pension fund, though already an investor in Bridgewater’s funds, will now have a 20% stake in Bridgewater as a result of its $250 million investment, and will share in the manager’s future profits.
Hedge Fund Company Valuation
In a recent article, Dr. Donald May detailed the considerations that partners in a hedge fund need to take into account in the valuation of their fund. Dr. May pointed out that the nature of hedge funds makes valuation of partner shares complex and ambiguous, leading to potentially high costs upon the departure of one or more partners. According to Dr. May, to reduce ambiguity and future break-up costs, guidelines for the valuation of investments should be linked to the assets that the fund invests in, and the fund’s overall investment strategy. The optimal way to take all the complexities of the situation into account is to craft a partnership agreement that specifies how valuations and payouts will be determined, ideally leading to a single valuation or range of valuations that reflect the expectations of the fund partners. It is important to foresee these ambiguities in crafting a partnership breakup agreement that will lead to an orderly departure of partners, as opposed to a drawn-out litigation that could be very expensive and potentially destroy the fund itself. There are three main valuation methodologies when valuing companies: the comparable company method, the comparable transactions method and the discounted cash flow (DCF) method. Companies which are the target of valuation attempts are typically analyzed using all three methods. To arrive at a final valuation, the valuations generated by each of these methods are weighted depending on their relevance to the particular company. For example, less weight would be applied to the comparable company method if a company does not have comparable peers. Careful analysis of the industry and the firm must be conducted in order to weigh each method appropriately for deriving a final valuation. The sections that follow present some of the research and analysis conducted by SFC on the relevance of each method when valuing hedge funds.
I. Comparable Company Method
Finding comparable companies for hedge funds and other alternative managers means finding publicly listed firms. Although in the past few years more alternative asset managers have become publicly traded, a vast majority remain private. Exhibit 2 and 3 show key valuation statistics for publicly traded traditional and alternative asset managers. The AUM multiple is one of the key variables that has historically been used in the valuation of investment managers. It is derived by dividing the market capitalization of the firm by its assets under management. This allows for an easier comparison between the valuation of traditional managers and alternative ones, and we notice that the median for alternative managers, 7.91% is higher than that of traditional managers with a median of 1.77%. One reason for this could be that private equity and hedge fund firms may potentially enjoy much higher revenues than mutual funds and other types of investment management firms when performance fees are included. Also, unlike in the case of open-end mutual funds where investors can redeem their shares at the end of day NAV, private equity firms and hedge funds tend to have longer capital lock-up periods and more restrictions on redemptions, ranging anywhere from a month to 28 months. This keeps their assets under management relatively stable, bringing in revenue through management fees even in years of underperformance, leading to higher AUM multiples. Out of this list of alternative asset managers only Och-Ziff Capital Management Group LLC and Man Group Plc. are true hedge fund firms. The rest of the alternative managers are private equity firms that may also have hedge fund units within. Therefore this method will carry a small weight in the final valuation, when valuing a hedge fund.
II. Comparable Transactions Method
Over the last ten years there have been a number of transactions in the hedge fund industry. While most of time deals terms are not publicly disclosed, there are still enough publicly disclosed deals to validate the use of this method. SFC has identified 88 hedge fund deals between 2002 and 2012, excluding fund of funds manager transactions. Exhibit 4 shows the deals with terms that were publicly disclosed over the ten year period.
One thing that is evident from Exhibit 4 is that the AUM multiple varies greatly, ranging from as little as 0.04% to 40%, with a median of 5.8%. There are several possible factors that could have contributed to the wide range of AUM multiples observed in these transactions. Important considerations for examining a firm’s value include its AUM, the strategy employed by the fund, historical performance, inception date, AUM growth, the manager’s experience and reputation as well as affiliation. Hedge fund performance can be highly volatile; Exhibit 5 shows mean returns and standard deviations of various strategies as compared to the S&P and treasuries. The investment classes invested in and strategies employed by the fund affect the level and volatility of returns. The median AUM multiple for multi-strategy and emerging market focused fund transactions were 8.18% and 3.91% respectively, while credit focused funds had a median multiple of 3.75%. Characteristics of the buyer are also important when using the comparable transaction method. For example Carlyle Group, a private equity firm, paid $156 million for a 55 percent stake in Emerging Sovereign Group, a deal with a 17.67% multiple. At the time of this acquisition, Carlyle had been attempting to expand its product mix before going public in order to attract more money from investors. In April 2007 Citigroup paid the richest valuation yet for Old Lane Partners out of our list of publicly announced deals, paying a multiple of 17.78%. Citigroup was perhaps more interested in the deal because one of the founders of Old Lane, Vikram Pandit, who went on to become the CEO of Citigroup. So as it is evidenced by these two cases, the characteristic and motivation of the buyer in each case is different and needs to be factored into the valuation analysis. In summary, though there is enough breadth of announced hedge fund transactions to be able to reasonably rely on this method, proper discounts must be made to the AUM multiple to account for some of the considerations that were discussed above.
III. Discounted Cash Flow (DCF) Method
The DCF is still the foremost used method when valuing hedge funds and most companies. This method discounts a company’s future cash flows to the present to derive an estimate for the value of the company. This method is what is known as a two stage model. The first stage involves making income and expense projections three to five years out and calculating the terminal value. Then in the second stage, the projected cash flows and terminal value are discounted by the relevant rate to arrive at a present valuation for the firm. While most hedge funds don’t publicly disclose their financials, because the revenue and expense structure is largely the same across most funds it is possible to make some assumptions about cash flows. Revenue for hedge funds is a function of the fund’s assets under management as well as its performance. Revenues are comprised of a management fee, typically ranging from 1% to 2% of assets under management, and a 20% or higher in incentive/performance fees for most managers.
Multiplying the assets under management of fund by 1% approximates the firm’s revenue from management fees; the higher the firm’s asset base, the greater the management fee revenue. Assets managed by a fund can be very volatile as market conditions and performance become volatile. However, firms with more stringent withdrawal terms or longer capital lockup periods can ride out adverse market conditions as they have a stable revenue stream. Compensation represents the most significant cost for most asset managers and it is the same for hedge funds. Reducing the management fee revenue by about a factor of one to two-thirds to account for compensation costs and other operating expenses yields the income from management fees. Something to take into account when calculating the income in this manner is that the use of deferred compensation has risen over the past few years. A firm’s compensation structure will affect cash flows differently in different years depending on when actual payments are made and it is something that needs to be accounted for while making cash flow projections.
Most hedge funds take what they call performance/incentive fees on a yearly basis. These are more difficult to translate into a valuation because performance fees depend on both assets under management and the fund’s performance. As discussed above, the fund’s strategy is a significant determinant of its performance, as the global market environment is subject to change and different asset classes go through different cycles; as a result, not all strategies perform well in every market environment. For example, in Exhibit 4 we see that global macro focused hedge funds posted a mean return of 12.67% while dedicated short funds lost -2.33% on average. However, strategy performance during particular market phases is far from the sole determining factor in manager performance; hence, the need to assess both the pedigree and skill of the manager in addition to the strategy employed. Performance based revenue calculation is also complicated by the presence of “high water mark” levels. A high water mark is the highest net asset value (NAV) achieved by the fund. If at year end the NAV of the fund has risen beyond this point, the manager will typically collect 20% as a performance fee on the portion of the profits, measured by the difference in NAVs. However, if the NAV of the fund has been declining year over year, the manager will not receive any revenue from performance fees until the NAV has risen above previously established the high water mark point. Most analysts typically average the last 2 – 3 years’ worth of a fund’s results and allocate between 50 – 75% of the performance revenue to compensation and bonuses to arrive at a number for net income from performance fees. Once cash flow projections have been made three to five years out, we have to calculate the terminal value. The terminal value is the component of the firm’s valuation that is the result of the cash flows it generates as it continues operations in perpetuity. This is a difficult calculation as it requires the analyst to come up with a constant growth rate for cash flows. To forecast future cash flows it is necessary to look at net asset flows in the industry as well as to analyze the individual size and performance of the hedge fund in question. Exhibit 1 shows that there was a huge outflow following during the market turmoil in 2007 and a steady flow of capital into hedge funds beginning in 2009. So it is reasonable to conclude that hedge funds will experience outflows in bear markets and inflows in bullish ones, which are assumptions that need to be baked into the cash flow projections. There is a complex dynamic relationship between the size of a fund and its performance; therefore, not all funds will experience the same level of net cash flows. While this topic will not be expounded upon in-depth in this article, there have been numerous studies conducted on the relationship between fund size, performance, and asset flows, which must be afforded careful consideration when creating an assumption for the growth rate of a fund’s future cash flows. Ideally, one would use the DCF method, along with a scenario or Monte Carlo component, which is especially useful when there is no history available for a fund or it’s a relatively new fund. Scenario analysis allows for the analysis of possible of different outcomes under varying assumptions. So, if one were to use a scenario analysis in their DCF valuation, they could project future cash flows under several market condition assumptions such as bear, moderate and bull markets using computer models. A Monte Carlo simulation may also be used to estimate the probability of a certain outcome occurring by running multiple trials using a computer model. One would use this method to assign probabilities to future cash flows of a fund. However, this is a complex endeavor and one that is very time consuming, as it can only be done on a case-by-case basis.
Valuing a hedge fund is a complex and difficult exercise. While there has been a growth in publicly listed alternative asset managers, as well as more M&A activity in the hedge fund space to provide more reference points for the comparable company or the comparable transaction methods, the DCF method is still the preferred approach. However, DCF analysis can be very complex due to the complicated and unique structure of hedge funds. With all methods, proper considerations must be made regarding the structure, strategy and size of the fund in addition to the general market conditions to properly value a hedge fund. In conclusion, it is crucial to stress that these are guidelines and not hard and fast rules. Hedge fund valuation is a complex subject and detailed analysis of each hedge fund’s case must be conducted before coming up with a final valuation for the fund.
About Ezra Zask
Ezra Zask has spent over 30 years in the finance and investment areas, providing research and consulting to investors and investment management companies. He has founded and managed a hedge fund, fund of funds and investment advisory firms, ans held senior positions in hedge funds and investment advisory firms. He has taught at Princeton and Yale graduate schools and written extensively including a best-selling book, All About Hedge Funds, Second Edition (McGraw Hill: 2013)