By David Rudman, CPA/ABV, CVA – Sigma Valuation Consulting, Inc.
Attorneys who represent clients in estate planning matters or marital dissolution cases may discover that their clients are in the business of owning and/or managing alternative assets. Two of the most common types of alternative assets are private equity funds and hedge funds. While their structures are similar, investment terms and the criteria for compensating general partners vary. Acting as the general partner or investment manager of such funds can represent many millions of dollars in carried interest and incentive fee compensation. As a result, it is important to hire the right expert with experience in valuing these interests who can support efficient planning and case resolution. Most importantly, obtaining a defensible valuation will mitigate risk and help to avoid common mistakes that can lead to challenges down the road.
Alternative Assets Defined
The alternative asset management industry commonly includes hedge funds, private equity funds (“PE funds”), venture capital funds and commodity pool operators. Qualified investors are attracted to alternative asset investments due to the potential for higher returns, often with hedged risks. These investors typically include pension and endowment funds, institutional investors, as well as individual accredited investors.
PriceWaterhouseCoopers predicts that by 2020, investments in alternative assets could grow to between $13.8 and $15.3 trillion. According to Yahoo Finance[1], there are more than 10,000 hedge funds and by some estimates the number could be as high as 15,000. The space has become very crowded.
Steve Cohen, who runs the $11 billion family office, Point72 Asset Management (formerly SAC Capital), recently spoke at the Milken Global Institute Conference, and said there are “too many players” in the hedge fund space. With such a crowded space, many hedge funds are unable to deliver the performance they advertise.
Although hedge funds are self-reporting and do not report to the SEC, according to the data firm, Hedge Fund Research, more hedge funds closed down in 2015 than were opened.
The PE fund space is also very crowded, with many funds having a difficult time deploying capital and finding quality acquisition targets. Larger private equity firms have also experienced challenges in accessing debt financing to close deals in the past year. Like smaller hedge funds, smaller private equity firms also have a higher risk of failure.
So what is the attraction? — Earning a high level of compensation as a general partner or investment manager of a fund through successful performance. Additionally, for most private equity fund managers, the current federal tax code allows the treatment of such compensation as long-term capital gains which are taxed at a lower rate than ordinary income tax rates reported by most taxpayers.
Fund Structure
While the organizational structures tend to be similar, there are differences between how general partners (investment managers) are compensated in private equity funds and hedge funds. These differences can be critical when determining the value of their interests.
Though the management compensation structures differ between hedge funds and PE funds, they are similar in one respect. Generally, fund managers are paid through a compensation structure often referred to as the “2 and 20 rule.” Under this fee structure, investors are charged management fees of 1.5% – 2% annually of total assets under management. The fund’s general partner receives a carried interest (in the case of a PE fund) or performance fee (in the case of a hedge fund) of 20% of any profits once certain performance targets are hit. Fees can vary from fund to fund, with some charging less and others charging more. Carried interests are generally calculated and distributed at the end of each calendar year or reporting period. Presented below is a diagram detailing the typical simplified hedge fund/PE fund structure. As shown, the subjects of valuation are usually interests in the General Partner entity, Management Company, and sometimes, the Master Fund.
Private Equity Funds
Private equity is a generic term identifying a family of alternative investing methods. PE firms generally invest in the equity of privately held companies or real estate, as well as vehicles that hold debt investments. These funds are often classified into categories according to the investment strategy of the fund, such as leveraged buyout funds, growth equity funds, venture capital funds, real estate investment funds, and mezzanine or distressed funds. Investments in PE funds tend to be illiquid with a fund life of 3 to 10 years.
Private equity general partners who function as investment managers are responsible for making all decisions surrounding the activities of the fund, including acquisitions, and capital calls and divestitures. In exchange for this oversight, a management fee is received by the management company which is used to fund its operating expenses. As discussed previously, the management fee component usually falls in the range of 1.5 to 2% annually of fund value. Typical expenses incurred by the management company include employee compensation and bonuses, rent, research and data costs, travel, insurance, and professional fees.
The typical fund structure is complex with the management company usually formed as a separate entity. In some cases, the general partner entity will own the management company. In others, the management company and general partner entity will be separate entities owned by the same individuals.
In private equity structures, the distribution of carried interest is directed by a distribution “waterfall” that is spelled out in the fund’s offering documents. Generally, in order to receive carried interest, the manager must first return all of the limited partner investors’ (“LP investors”) contributed capital. In addition to a return of capital, many PE funds also provide for a preferred return (or hurdle rate) to the LP investors before any carried interest will be earned by the general partner. The customary preferred return in private equity is 7–8%. As a result of the distribution waterfall and the long investment horizon, the general partner usually only receives its carried interest upon a successful exit from an investment, which may take years.
As discussed previously, the typical carried interest is 20% of the private equity fund’s profit after hitting certain performance targets. This fee can vary from fund to fund. In many cases, the general partner is also required to own a limited partnership interest, just like other LP investors in the fund. Often, LP investors are more comfortable knowing the general partners have some of their own capital at risk.
Hedge Funds
Hedge funds are investment companies that manage pooled investment funds and generate income by charging management and performance-based fees to the funds under their management. Hedge funds generally invest in marketable securities and attempt to hedge their downside risk. They are less regulated than mutual funds and can invest in a wide range of asset classes while pursuing a variety of investment strategies. In comparison to PE funds, which do not provide investment liquidity, hedge fund investments are much more liquid, usually allowing redemptions on a quarterly or annual basis following an initial lock-up period of typically one year.
Like PE funds, a hedge fund provides an economic benefit referred to as performance or incentive fee, that accrues to the fund’s general partner as compensation for successful management. As discussed previously, performance fees are usually 20% of fund returns, but there is a key difference. General partners in hedge funds are paid only when the value of the hedge fund hits what is referred to as a “high-water mark” — which represents the greater of 1) the highest net asset value of one’s capital contribution as of the end of any previous reporting period, or 2) the amount of the initial capital contribution. This means that if a fund loses 5% from its previous high-water mark, the manager will not collect a performance fee until he or she has first made up the 5% loss and the fund has moved higher. In contrast to PE funds which must wait until portfolio investments are liquidated, every time the high-water mark in a hedge fund is surpassed, performance fees are earned.
Valuation Approaches
For estate planning or marital dissolution purposes, attorneys are often tasked with finding a valuation expert who has the necessary experience to value interests owned in the multitude of entities that form these complex alternative asset investment management structures.
While the approaches to valuation are no different than those used to value other companies, understanding the complexities of these management structures and the inputs that drive the valuations is critical to achieving a defensible valuation.
For businesses, there are three generally accepted approaches to valuation:
1) the Market Approach;
2) the Asset Approach; and
3) the Income Approach.
The Income Approach focuses on the income-producing capability of the business. The Market Approach focuses on the prices of similar companies, and the Asset Approach focuses on the net asset value of the enterprise.
The Market Approach is generally not appropriate for valuing interests in private equity or hedge fund management companies for several reasons. A typical, privately held management firm lacks diversification and large asset bases typically seen in publicly traded PE and hedge fund management companies. Unlike private firms, market data is only available on very large, well-diversified managers. Private fund management companies also typically have “key person” issues in which success depends significantly on a single or small number of managers. Using public data to value private firms also presents difficulties, as it is often necessary to value certain entities within a larger PE fund or hedge fund structure rather than the entire collective business. When using market data from publicly traded firms, segmented market data simply isn’t available.
The Asset Approach tends to set a lower range to valuation for any business due to the fact that the approach generally doesn’t recognize goodwill. Accordingly, for profitable businesses such as PE fund and hedge fund management companies, the approach is generally not appropriate. The asset approach is appropriate however, for valuing the general partner’s interest in the fund itself, which is necessary when the general partner is required to have some of its own assets at risk.
As a result, the Income Approach is the most commonly applied approach used to value PE and hedge fund GP entity and management company interests. Within the Income Approach, PE carried interests are typically valued in two ways: the Discounted Cash Flow (DCF) Method and Option Pricing Method. For hedge funds, GP interests that receive performance fees are generally valued using the DCF method, as explained later.
In essence, we are valuing the projected cash flows received by the general partner in the form of carried interests (PE funds) or performance fees (hedge funds), and any fees (net of expenses) collected through the management company. As discussed previously, in most cases, the general partner is also required to keep some of its own money at risk as an investment in the fund itself. This investment along with any potential returns must also be considered in the course of valuation.
For both hedge funds and PE funds, the cash flow potential for general partners is a function of the LP investors’ assets under management (AUM) and rate of return generated on the AUM. For GP interests in established funds, it may be possible to look to a fund’s historical rates of return as a starting point to project carried interests or performance fees. For new funds, developing projections is more difficult as there is no historical baseline on which one can rely. In both cases, the valuation expert must consider the risk associated with realizing those returns.
Discounted Cash Flow Method
The discounted cash flow method projects future cash flows expected to be generated via carried interests or performance fees and discounts them at a rate of return commensurate with the risk inherent in realizing the cash flows. This method requires making assumptions regarding the hedge fund’s or private equity fund’s required rate of return, investment holding period, and GP cash flows which are then discounted to present value.
The two most important components in a discounted cash flow of valuation are:
Projected cash flows
Discount rate
The application of the DCF method to value management interests in PE and Hedge Funds typically involves the following steps:
Projecting the funds’ AUM, which considers future expected investment returns, investors’ contributions and redemptions from the fund, fund closures or new fund launches as well as other factors that are known or knowable as of the date of valuation;
Projecting management fees (and carried interest distributions) based on the forecast of AUM;
Projecting the management company’s operating expenses, based on the analysis of historical costs and expected expense levels, giving proper consideration to reasonable compensation issues;
A development of the appropriate discount rate for both the GP entity (receiving carried interest distributions) and for the management company (receiving management fees);
Discounting the future expected cash flows to present value to derive the values of the entities that receive carried interest and management fees;
The valuation expert must also consider applicable valuation discounts (such as a discount for lack of control and/or a discount for lack of marketability) necessary to arrive at the value of a non-controlling ownership interest in the general partner entity or management company. Discounts may or may not apply depending on the purpose of the valuation, applicable standard of value, and jurisdiction/venue where the report will be used or submitted.
In the DCF model, the discount rate is highly subjective and should be backed by credible inputs and experienced judgement. The rate of return used to discount the projected cash flows is correlated with the expected/required portfolio return for the entire fund and can be derived in part from this return. In the context of private equity funds, since the fund’s investors receive preferred returns before any net proceeds are paid to the carried interest holders, the projected cash flows attributable to the carried interest are considerably riskier than the projected cash flows associated with the limited partners’ investments in the fund. As a result, the required rate of return applicable to the carried interest tends to be higher than the gross portfolio rate of return on the PE or hedge fund’s AUM.
The cash flow projections used in the DCF method must also be credible, appropriate and admissible in litigation if necessary.
Key Differences Between Inputs in Valuing PE Funds and Hedge Funds Using the DCF Method
Projection Period Considerations
Unlike the valuation of traditional operating companies, the assumption of perpetual operation is often not valid in the context of PE fund valuations. PE funds have finite lives and their longevity depends on the size of AUM, the type and diversity of the investor base, and many other factors outlined in the private placement memorandum and operating/partnership agreement. In comparison, the ability of hedge funds to perpetuate their existence depends on the general partner’s ability to raise additional capital and achieve a high level of investment performance. While a PE fund’s carried interest may be valued using a discrete or finite set of projected cash flows over the defined life of the fund, the valuation of a hedge fund’s performance fee will generally be based on a discrete projection of cash flows coupled with a residual period that is capitalized into perpetuity. In other words, the life of a PE fund is limited, while the life of a hedge fund is perpetual.
Inconsistent Timing of Cash Flow
Cash flow patterns also vary in that PE funds collect management fees, make capital calls and deploy cash to make acquisitions during the early stages of a fund’s life. Carried interests for a PE fund’s general partner will not be earned until the fund begins liquidating investments, which usually occurs toward the middle or later stages of a fund’s life. In contrast, hedge funds can earn performance fees immediately after the launch of a new fund, but only if the fund generates investment profits for its LP investors.
Investor Redemptions
Investments in private equity funds are generally illiquid as most funds forbid the withdrawal of LP investments prior to the termination of the fund. Therefore, for private equity funds, when projecting the returns expected to be generated by the fund, no consideration needs to be given to redemptions of investor capital.
In comparison, most hedge funds tend to remain open to new or additional investments, allowing the general partner to raise additional limited partner capital. As discussed previously, hedge funds also allow investor redemptions after a relatively short lock-up period. Therefore, a reduction in capital due to investor redemptions must be considered when projecting the future returns of the fund.
Uncertainty
Obviously, projecting the future is not an easy task. While generally easier for mature hedge funds that have a proven pattern of historical returns, or private equity funds that have already deployed their capital, valuing management interests in newly formed management structures can be more challenging. Management interests in new funds have additional inputs that need to be modeled such as the potential size of the fund and timing of capital deployment. With a lack of operating history, the risk associated with hitting performance benchmarks is also more difficult to project. As a result, it is not uncommon for valuation experts to use a series of projections, or multiple case scenarios, with different outcomes along the spectrum of possibilities. When multiple scenarios are modeled, it is also necessary to apply probabilities of success to each case scenario. Instead of using static scenarios, the use of Monte Carlo simulation is also a possibility.
Option Pricing Method
As stated earlier, the valuation of performance fees in a hedge fund is derived from its expected cash flow after consideration of the risk associated with realizing those cash flows. Unlike private equity, hedge funds do not have specific termination dates, and hedge fund investors can usually withdraw their capital after meeting certain fund-specific requirements. Thus, while the discounted cash flow method is generally used to value the GP entity receiving the performance fee in a hedge fund, the option pricing method tends to not be applicable. The option pricing method does however lend itself to a GP’s carried interest valuation in a PE fund.
Accordingly, a carried interest may be valued using standard option pricing theory as it gives the holder the right to the value of an asset over a specified threshold (i.e., the strike price) for a specified period of time. As it relates to a carried interest, the strike price is the capital contributed by investors plus the preferred return.
Option pricing models were developed using the premise that if two assets have identical payoffs, they must have identical prices to prevent arbitrage or riskless profit. The most common option pricing model used to value carried interests is the Black-Scholes-Merton (“BSM”) model, which considers five variables in calculating the price of a traditional call option:
asset price
strike price
time to maturity
risk-free rate of return
price volatility of the underlying asset (i.e., risk)
When applying the option pricing model to value a carried interest, a portfolio of call options (with different strike prices) is modeled. In order to determine the various strike prices, it is first necessary to determine the breakpoints present in the fund’s distribution waterfall. Then, the BSM model is applied to determine the values of the carried interest and limited partnership interests in the fund.
The model is attractive due to its relative simplicity, as it is unnecessary to make assumptions for future fund returns, timing of investments or discount rates. Rather, the main inputs to the model are the volatility of the fund’s future investments and the expected life of the fund. The simplicity of the model is however, also one of its inherent weaknesses. Using a single volatility factor may not accurately capture fluctuations that exist over the life of a private equity fund.
Non-controlling Interests
When valuing non-controlling interests in the general partner entity and/or management entity, the purpose of the valuation, venue, jurisdiction and applicable standard of value are all critical to understanding whether valuation discounts for lack of control and lack of marketability should (or should not) apply.
For tax valuations, the standard of value is Fair Market Value. The fair market value standard by its definition, considers valuation discounts when deriving the value of a non-controlling interest. However, in the context of shareholder disputes or marital dissolution actions, state law will dictate whether the appropriate standard of value is Fair Market Value or Fair Value. Case law will further dictate what has been acceptable to the courts in the past. For example, in New York marital dissolution matters, the appropriate standard of value is fair market value. Under this standard, valuation discounts are applicable. In contrast, for marital dissolution matters in the State of New Jersey, the standard of value is fair value, and valuation discounts are generally deemed to be inappropriate. As shown, understanding the appropriate standard of value and applicable law is critical to achieving the correct valuation opinion.
Conclusion
Private equity and hedge funds management structures have potential to represent a significant source of income and wealth for a fund’s general partners (and often employees) in the form of carried interests or performance fee compensation. Despite this potential, carried interests and performance fees are often not received until some point in the future. As the cash flows associated with these interests are subject to many variables, significant risk exists regarding whether such cash flows will ever come to fruition, especially for new funds that do not have a track record of past performance.
Additionally, with the upcoming presidential election, there is an elevated level of political pressure to increase the tax rates to ensure that income that would otherwise receive long-term capital gains treatment is taxed at ordinary income tax rates.
From an estate planning perspective, the current market environment presents significant opportunities to structure estate plans for general partners of hedge funds and private equity funds at attractive valuations. In the context of divorce, it is essential to engage an expert who understands the complexities of these structures and nuances that must be considered when valuing such interests.
To learn more about the approaches and methods to the valuation of interests in private equity or hedge funds — and common mistakes to avoid — view our next article, “Common Errors in the Valuation of PE and Hedge Fund Interests”
David Rudman, CPA/ABV, CVA is the President of Sigma Valuation Consulting, Inc., a Certified Valuation Analyst, Accredited in Business Valuation by the AICPA. Mr. Rudman has over 20 years of experience valuing companies for marital dissolution, shareholder disputes, estate and gift tax planning and administration, and financial reporting.
Sigma Valuation Consulting, Inc. is a forensic accounting and business valuation firm with offices in New York City, Long Island, and New Jersey. The Company has successfully provided services to over 1,200 clients since its founding in 2006.
[1] Hedge funds — there are too many of them and most of them are lousy, by Julia La Roche, May 7, 2016.