Valuation of Hedge Funds
Poniachek, Harvey, The CPA Journal
Moving Toward Greater Standardization
The term hedge fund, as generally defined, means a pooled investment vehicle that is privately organized, administered by a professional investment manager, and available to institutional investors and high-net-worth individuals. Hedge funds do not, however, constitute an asset class in the way that stocks, bonds, commodities, or real estate do. Hedge funds conduct various investment activities, such as selling securities short and buying securities on leverage. They utilize derivatives and assume high-risk strategies. Hedge funds are also exempt from SEC reporting requirements and regulatory restrictions concerning trading strategies.
As hedge funds grow in size and complexity-increasing fifteenfold since 1993 to $1.5 trillion-their number has similarly increased to more than 9,000 funds (Governor Kevin Warsh, testimony before the House Committee on Financial Services, July 11, 2007). Valuation practices have become increasingly important for hedge fund managers, investors, and regulators. Valuations seek to determine the fair values of investment positions held by hedge funds, which, in the aggregate and after fees and expenses, correspond to the net asset value (NAV) of the funds. Valuation is paramount for the NAV calculation, which forms the basis for determining investment performance and compensation of fund managers. Concerns with in-house valuation stem from the inherent difficulty of valuing complex or illiquid instruments, and from the potential conflict of interest among the stakeholders. Stakeholders include management, investors, creditors, counterparties, and employees. If valuation is exaggerated, for example, managers' compensation would be favorably affected, but investors might be disadvantaged. If poor valuation is systematic and prolonged, the fund might ultimately close, to the detriment of all stakeholders. As a result, there has been increasing demand to ensure that valuation methodologies are reasonable and consistently applied.
There are various approaches to determining the fair value of a hedge fund, and one must recognize that funds reflect different investment styles or strategies and different assets. Ideally, valuation could be done by valuing each specific asset (or liability) and then aggregating them to yield the fund's total value.
Hedge funds are difficult to value because of the variability of their revenues and risk. Yet, the general methodologies commonly used to value companies in mergers and acquisitions (M&A) can be useful for hedge funds (see Ezra Task, "Hedge Funds: A Methodology for Hedge Fund Valuation," Journal of Alternative Investments, Winter 2000). According to the above approach, aggregate valuation could be derived through the market approach, which is based on comparable publicly listed company multiples, as well as through the income approach, which utilizes the discounted cash flow (E)CF) methodology.
In the absence of comparable hedge funds, application of the comparable approach could utilize asset management companies and mutual funds. Valuation of a hedge fund via the DCF methodology involves projections of free cash flows to equity for three to five years and derivation of their present value. Because the life of a business enterprise is assumed to be infinite, its value to perpetuity-also referred as the terminal value-is derived via the formulary approach of the Gordon Model. Assumptions about growth beyond the forecast years and the discount rate are crucial when deriving the value. Approximately 75% of the entire valuation is commonly embedded in the terminal value (see Zask 2000; James R. Hitchner, Financial Valuation: Application and Methods, 2nd Ed., Wiley, 2006; and Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, 4th Ed., McKinsey & Company, Wiley, 2005.)
The practical issue is whether the general business valuation methodologies are applicable to hedge funds. …