By David Rudman, CPA/ABV, CVA – Sigma Valuation Consulting, Inc.
As you may recall in my prior article published in the American Bar Association’s eReport to its Trust & Estates and Real Property Sections titled, “A Primer on the Valuation of Hedge Fund and Private Equity Fund Management Interests,” we noted that General Partners or Investment Managers of such funds can realize millions of dollars (or even billions) in carried interest and incentive compensation. We also discussed the complexity of valuing such interests, and why the selection of the right expert is critical to mitigate or avoid disputes in the context of potential litigation. In this follow-up article, we dive deeper into five of the most common mistakes made by valuation experts when valuing carried interests and management interests in private equity (PE) and hedge fund structures.
Mistake #1: Forgetting About AUM
The Income Approach is the most commonly applied approach used to value private equity and hedge fund management 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 incentive fees tend to be limited to the DCF method.
The application of the DCF method typically involves forecasting the funds’ assets under management (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. Performance fees (carried interests) and management fees are inherently tied to AUM.
Unfortunately, some experts forget or ignore the fact that the expected levels of AUM and future investment returns are fundamental value drivers for both hedge funds and private equity funds. As a result, experts must consider AUM on both a historical and forward-looking basis. Those that don’t will have projections results that do not make sense and lack internal consistency. If, for example, capital-raising activities have slowed or the fund is no longer actively marketed, AUM may stabilize and earnings may not continue to grow at historical rates. Accordingly, it is critical that any income statement and cash flow projections ultimately tie back to internal projections of AUM.
Mistake #2: Assuming Investment Returns Based Only on History
Let’s look deeper at investment returns. One of the biggest sources of potential disputes or disagreement among experts when valuing hedge funds involves investment return assumptions. Many experts often assume that a hedge fund’s historically high investment returns will continue in the future, while in reality, this is not likely to be the case. We have all heard the saying, “Past performance is not a guarantee of future results” and almost every prospectus contains similar language.
There is a high level of risk associated with realizing expected cash flow within a hedge fund or private equity fund, which ultimately drives the performance fees to be received by the general partner.
Valuation experts that do not possess the necessary industry knowledge and experience valuing hedge fund management structures often err by assuming historically high investment returns will continue indefinitely, resulting in unreasonable valuation conclusions.
Mistake #3: Using a Single-Period Valuation Model Instead of a Multi-Period Projection
When valuing hedge funds or PE funds, some experts rely on a single period valuation method, namely, the capitalization of earnings method to value fund management structures. In the context of divorce or commercial litigation, such experts often argue that the simplicity of the method is easier for judges to understand. The capitalization of earnings method is a valid method used to value a company when a company has stable predictable earnings that are assumed to continue on a long-term, sustainable basis at a constant rate of growth. The reality is, that this fact pattern rarely exists for private equity or hedge fund management companies.
In contrast, the discounted cash flow method (DCF) projects a carried interest’s expected future cash flows, and then discounts them at a rate of return commensurate with the risk inherent in realizing those cash flows. This method requires making assumptions regarding the hedge fund’s or private equity fund’s rate of return and investment holding period, and then applying an appropriate rate of return to the cash flows over the specified holding period — which in the case of private equity is not perpetual.
Mistake #4: Failure to Draw Lines of Distinction Between Economic Interests and Capital Interests
One common mistake made by valuation experts who lack experience valuing interests in hedge fund management structures is that they automatically assume that an employee’s tax form K-1 represents their respective ownership in the fund’s general partner entity.
In most partnerships or limited liability companies, a tax form K-1 is issued to an owner and represents the equity ownership in the company. However, this is not always the case in the context of hedge funds. It is not uncommon for a hedge fund employee to be issued an economic right to share in the carried interest earned by a hedge fund GP entity. In many cases, this economic right is simply a profits interest with no actual equity ownership interest in the fund’s GP. For tax purposes, such an interest is treated as a partner of the GP entity, despite the fact the employee does not actually have an equity ownership position in the fund’s general partner.
When valuing the interest of a general partner in a fund, it is critical that the valuation expert understand these nuances, so as not to over value the general partner’s interest.
Mistake #5: Treating New Fund Management Structures the Same as Mature Funds
It is not uncommon to see valuation experts fail to consider the extra risk associated with valuing a new hedge fund or private equity fund structure (when compared to an identical mature fund). It is generally acceptable to consider some historical performance for mature hedge funds that have a proven pattern of historical returns — or private equity funds that have already deployed their capital. However, valuing newly formed management structures can be more challenging.
New fund structures have additional inputs that need to be modeled such as the size of the fund and timing of capital deployment. With a lack of operating history, the risk associated hitting performance benchmarks is also more difficult to project. The failure to account for the additional level of uncertainty present in a new fund can result in overvaluation. Valuation experts who are experienced in valuing hedge fund or private equity fund management structures, will often account for this extra risk in one of two ways. Some will use a series of projections with different probability weighted outcomes along the spectrum of possibilities. The extra risk is captured by having multiple projections with different assigned probabilities of success. A less sophisticated, but acceptable approach is to increase the discount rate used to bring cash flow projections back to present value. The use of Monte Carlo simulation is also a possibility, but may be difficult for a trier of fact to understand.
Conclusion
If you have clients who act as general partners and investment managers in private equity funds or hedge funds, hiring the right valuation expert is of critical importance. 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 and business disputes, it is essential to engage an expert who understands the complexities of these structures and the nuances that must be considered when valuing such interests. Don’t let these common valuation mistakes derail the outcome of any litigation or planning on behalf of your client.
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, healthcare compliance, and financial reporting.
Sigma Valuation Consulting, Inc. is a forensic accounting and business valuation firm with offices in New York City, Long Island, Westchester and New Jersey. The Company has successfully provided services to over 1,250 clients since its founding in 2006. Visit us at www.sigmavaluation.com.