VALUATION OF HEDGE FUNDSVladimir Korobov, CPA, ABV, ASA

Marcum LLP

Disclaimer

The views expressed in this presentation are personal opinions of the presenter, and are presented for educational and illustration purposes only. These opinions may not reflect those of Marcum LLP. Although information contained in this presentation has been carefully compiled from sources believed to be reliable, the accuracy of the information is not guaranteed. It is neither intended nor should it be construed as either legal, accounting, and/or tax advice.

• Introduction:• Hedge Fund Industry Overview• Current Industry Trends• Typical Valuation Subjects and Areas of Valuation

• Overview of Fund Management Structures and Terms:• Separate Management and GP Entities• Single Management and GP Entity• Key Operating Provisions

• Overview of Valuation Methodologies• Income Approach:

• Key Considerations and Steps• Discrete DCF vs. Simulation-Enhanced DCF

• Examples of Challenges and Issues in Valuation of Hedge Funds

Agenda

Introduction

Hedge Fund Industry Overview*

❑ AUM ≈ $3.1 trillion

*Source: Hedge Fund Research, Inc.

$0.5 $0.5 $0.6

$0.8 $1.0

$1.1

$1.5

$1.9

$1.4 $1.6

$1.9 $2.0

$2.3

$2.6

$2.8 $2.9 $3.0

$3.2 $3.1

3,335

3,904

4,598 5,065

5,782

6,665

7,241 7,634

6,845

6,883

7,200

7,574

7,940

8,190 8,425 8,474

8,256

8,335 8,331

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

$-

$0.5

$1.0

$1.5

$2.0

$2.5

$3.0

$3.5

Historical Industry AUM and Number of Hedge Funds

Industry AUM (In Trillions) Number of Funds

Equity Hedge

28.1%

Event Driven

26.4%

Relative Value26.9%

Macro18.7%

2018 Industry AUM by Strategy

74.3%

18.1%7.6%

2.4%

16.8%

80.8%

< $ 100M $ 100M to $ 1B > $ 1B

2018 Distribution of Industry AUM by Size of Hedge Fund

% of Funds % of Industry AUM % of Industry AUM

1. Reconsideration of hedge funds as an asset class by institutional investors;

2. Industry is still growing, but larger, more established funds tend to benefit from growth;

3. Significant pressure on fees – traditional “2-20” structure no longer works;

4. Wider acceptance of benchmarks and hurdle rates in measuring performance;

5. Regulations;

6. Re-emergence of investors in hedge fund management firms.

Current Industry Trends

1. Interests in management entities;

2. Profit-sharing arrangements/rights:a) Interests in general partner entities that

earn incentive/performance fees;

3. Fund interests;

4. Illiquid portfolio investments.

Typical Valuation Subjects Areas of Valuation

TaxGift / Estate Planning /

Compliance

TransactionsEquity grants to key employees /

admission of new partners

Investments in management and/ or GP entities by third parties

Financial ReportingDetermination of fair value of illiquid / private investments

LitigationMarital Dissolution

Business disputes

Valuation

Overview of Fund Management Structures and Terms

Fund Management Structures:Separate Management and General Partner (“GP”) Entities

Management

Company

Principals

Onshore Feeder

Fund(s)

Master Fund

Management Fees

Tax-

Exempt

Investors

Taxable

Investors

Offshore Feeder

Fund(s)

General Partner

Interest

InvestmentInvestment

General Partner

Entity

Performance

Fee

Incentive

Allocation

• Valuation Considerations:• “Singe-source” cash flow stream, i.e. the management entity receives

management fees, and the GP entity receives performance fees;

• Separate discount rates for management fees and performance fees’ cash flow streams;

• Need to address reasonable compensation and other issues for each cash flow stream;

• Potential issue with allocation of terminal value.

Fund Management Structures: Separate Management and GP Entities

Fund Management Structures:Single Management/GP Entity

Principals

Management

Company /

General Partner

Onshore Feeder

Fund(s)

Master Fund

Management Fee

Tax-

Exempt

Investors

Taxable

Investors

Offshore Feeder

Fund(s)

InvestmentInvestment

General Partner Interest

Performance

Fee

Incentive

Allocation

• Valuation Considerations:• In the single management/GP entity structures, the management/GP entity

receives two cash flow streams - management fees and performance fees/ carried interest distributions;

• A discount rate should reflect different risk profiles of the cash flow streams.

Fund Management Structures: Single Management/GP Entity

Typical Operating/Performance Provisions

Operating Provision Description

Fee Structure• Management Fee: 1%-2% of AUM;• Incentive Fee: 10%-20% of profits.

Investment Performance Measurement

• Generally, absolute return;• Increasingly, returns are measured against benchmark (e.g. index performance, yield on a Treasury security, excess return measures such as Sharp ratio);• Investment performance is subject to a “high water” mark.

Special Investor Redemption/ Withdrawal Rules

• Redemption notice requirement (30-90 days);• Redemption frequency (e.g. monthly, quarterly, etc.). Depends on investment strategy / liquidity;• Gate and lockup provisions are common, but are increasingly under pressure from investors.

Other

• Generally, no limit on fund’s life. In practice, however, longevity depends on ability to achieve consistent investment performance;• Incentive fees are usually paid out annually (subject to high water mark). Increasingly, a portion of incentive fees is deferred and paid out over time.

Overview of Valuation Methodologies

Valuation Methodologies

Income Approach

Preferred (and often the only viable) method

Discounted Cash Flows is typically utilized

Allows to explicitly model return and operating

assumptions

Can accommodate simulation techniques, such as Monte Carlo

Market Approach

Difficult to apply due to lack of information

Even if comparables are found, “key person” and other

issues make application of multiples problematic

Due to its shortcomings, Market Approach is

generally used only as a reasonableness check for

the Income Approach results

Asset Approach

Generally, used to value GP or holding entities in the investment company

structure that are not allocated fee income, and LP interests in the

investment funds managed

Option-Pricing Method

Option-pricing methods have found

application in valuation of carried interests in private

equity funds, but are difficult to apply in valuation of hedge

funds

Selection of Valuation Methodologies and Consideration of Fund Management Structures

Separate Management/GP Entity Structure

Single Management/GP Entity Structure

Management Entity (i.e. management fee cash flow stream)

• DCF for management fees (discrete or Monte Carlo simulation-enhanced), which yields the present value of expected net after-tax management fees (i.e. management fees less operating expenses and income taxes).

• Combined DCF for two cash flow streams (discrete or Monte Carlo simulation-enhanced), which yields the operating value of a single management/GP entity.

Incentive/Performance Fees

• DCF for incentive/performance fees (discrete or Monte Carlo simulation-enhanced), which yields the present value of expected after-tax incentive/performance fees.

Income Approach

• The income approach is often the only viable valuation technique, especially in litigation;

• Discounted Cash Flow Method (“DCF”) is the preferred valuation method within the income approach:• Although courts in some jurisdictions may favor the Capitalization of Cash Flow

Method over the DCF, the Capitalization of Cash Flow Method should generally be avoided in valuation of alternative asset management firms.

Income Approach: Application and Key Considerations

• A key difference between hedge funds and traditional businesses in a valuation context is that an assumption of perpetual operation is often not valid or at least needs to be explicitly evaluated in every case:• Hedge funds face a risk of closure due to persistent

underperformance;

• Age and intentions of the firm’s principals, and their ability and willingness to transition duties to others within the firm (i.e. “key persons” risk);

• Longevity also depends on size of AUM, and type and diversity of investor base.

Income Approach: Application and Key Considerations

Income Approach: Analytical Steps

Step 1: Analysis of Historical Investment Returns•Analysis of fund’s

historical returns (and benchmarks, if applicable).

•Discussions with management to understand historical performance.

•If Monte Carlo simulation is utilized, analysis of volatility and correlations of fund’s historical returns.

Step 2: Development of Gross Investment Return Expectations •Consideration of

investment strategy constraints, if any.

•Consideration of economic conditions.

•Monte Carlo or other simulation techniques can significantly enhance the analysis, but still require estimates of the mean return and volatility.

Step 3: Forecast of AUM•AUM as of valuation

date is a starting point.•Increases (decreases) in

AUM are projected for each discrete period in DCF based on projected gross investment return.

•Anticipated capital contributions/ redemptions.

Step 4: Forecast of Management Fees•Management fees are

projected based on the projected levels of AUM at each discrete period in DCF.

•Forecast must also consider any “tier” provisions (e.g. escalations or reductions in fees based on the expected levels of investors’ assets.

Step 5: Forecast of Performance Fees•Performance fees are

projected based on the projected levels of AUM at each discrete period, after management fees.

•Consideration must be given to “high water mark” provisions.

•Forecast must also consider vesting or deferral provisions.

Step 6: Forecast of Operating Expenses •Analysis and

normalization (if appropriate) of historical compensation and other operating costs.

•Determination of future base compensation for officers and employees.

•Determination of future performance-based compensation for officers and employees.

•Projection of other operating expenses.

Step 7: Determination of Appropriate Discount Rate(s)•Consideration of

available methodologies (e.g. CAPM, build-up).

•Development of discount rates for management and performance fees (blended for a single entity).

•Consideration of selected valuation methodology and its impact on discounts (e.g. discrete DCF v. Monte Carlo simulation).

Step 8: Determination of Value•Calculation of present

values of future net management fees and performance fees.

•Consideration of need for terminal value and appropriate terminal value methodology.

•Consideration of reported assets (e.g. investments in funds) and liabilities (e.g. deferred compensation, debt) in arriving at the equity value(s).

Income Approach: Analytical Steps

Income Approach: Discrete DCF Separate Management and GP Entities

Basic Facts:

• ABC Capital Partners is a HF firm with AUM of $1.5 billion as of June 30, 2019;

• Management Entity: ABC Capital Management, LLC;

• GP Entity: ABC Capital GP, LP;

• Investment Fund: ABC Fund, LP with two share classes (A and B) with different fee structures:

• Class A ($1.0 billion): 2% management fee, and 20% performance fee;

• Class B ($0.5 billion): 1% management fee, and 15% performance fee;

• Class C: non-fee-paying GP interest; nominal value.

• Principals receive base salaries and profit distributions;

• High water mark status:

• Class A shares are $50.0 million below HWM;

• Class B shares are $20.0 million below HWM.

Management Entity’s 2018 Results of Operations (in thousands)

Management Fees $25,000 100.0%

Operating Expenses:

Principals Salaries (800) (3.2)%

Employee Salaries (3,000) (12.0)%

Employee Bonuses (8,750) (35.0)%

Rent (400) (1.6)%

Taxes and Licenses (250) (1.0)%

Benefits (500) (2.0)%

Professional Fees (100) (0.4)%

Travel & Entertainment (200) (0.8)%

Market Data Access Fees (300) (1.2)%

Office Expense (500) (2.0)%

Depreciation (300) (1.2)%

Total Operating Expenses (15,100) (60.4)%

Operating Income $9,900 39.6%

Income Approach: Discrete DCF Separate Management and GP Entities

Valuation Assumptions:

• Valuation date is June 30, 2019;

• Subject interest of valuation is 100% equity of management and GP entities;

• Long-term expected annual gross investment return is 8%;

• Forecast period - 10 years;

• Reasonable compensation targets:

• Principals’ reported base compensation is reasonable;

• Under a hypothetical ownership, principals would be entitled to a discretionary non-performance bonus of 25% of management fees;

• Employees’ discretionary non-performance bonus is 35% of management fees;

• Total management entity’s target reasonable compensation level of 75% of management fees;

• Both principals and employees would be entitled to a performance-based bonus. The appropriate bonus pool was determined to be 65% of performance fees.

• Working capital: 2% of management fees for management entity; none for GP entity;

• Capital expenditures: 1% of management fees for management entity; none for GP entity;

• Discount rates: 15% for management entity; 25% for GP entity;

• Terminal value: 2.0% of AUM at the end of forecast period (year 2029).

Management Entity’s 2018 Normalized Results of Operations (in thousands)

Management Fees $25,000 100.0%

Operating Expenses:

Principals’ Salaries (800) (3.2)%

Principals’ Bonuses (6,250) (25.0)%

Employees’ Salaries (3,000) (12.0)%

Employees’ Bonuses (8,750) (35.0)%

Rent (400) (1.6)%

Taxes and Licenses (250) (1.0)%

Benefits (500) (2.0)%

Professional Fees (100) (0.4)%

Travel & Entertainment (200) (0.8)%

Market Data Access Fees (300) (1.2)%

Office Expense (500) (2.0)%

Depreciation (300) (1.2)%

Total Operating Expenses (21,350) (85.4)%

Operating Income $3,650 14.6%

Income Approach: Discrete DCFForecasts of AUM and Fee Revenue

AUM and Management Fees Performance Fees

Income Approach: Discrete DCFValuation of Management Entity

Terminal value is allocated between entities

1

2

3

Income Approach: Discrete DCFValuation of General Partner Entity

Terminal value is allocated between entities

Income Approach: Discrete DCFValue Conclusion

Valuation Assumptions:

• Valuation date is June 30, 2019;

• Subject interest of valuation is 100% equity of management and GP entities;

• Long-term expected annual gross investment return is 8%; expected return volatility is 10%;

• Forecast period - 10 years;

• Reasonable compensation targets:

• Principals’ reported base compensation is reasonable, but needs to be adjusted for inflation going forward;

• Under a hypothetical ownership, principals would be entitled to a discretionary non-performance bonus of 25% of management fees;

• Employees’ discretionary non-performance bonus is 35% of management fees;

• Total management entity’s target reasonable compensation level of 75% of management fees;

• Both principals and employees would be entitled to a performance-based bonus. The appropriate bonus pool was determined to be 65% of performance fees.

• Working capital: 2% of management fees for management entity; none for GP entity;

• Capital expenditures: 1% of management fees for management entity; none for GP entity;

• Discount rates: 15% for management entity; 15% for GP entity;

• Investor behavior assumptions:

• Negative performance in ONE year would cause redemptions of 10% of AUM the following year;

• Negative performance in TWO consecutive years would lead to a closure of the fund in the subsequent year.

• Terminal value: 2% of AUM at the end of forecast period (year 2029), but only if the fund survives.

Income Approach: Simulation-Enhanced DCFBasic Assumptions

Modeling investment return and

investor behavior

Monte Carlo simulation-generated random variable

Income Approach: Simulation-Enhanced DCF Value Conclusion

Income Approach:Comparison of Results of Discrete and Simulation-Enhanced DCF Analyses

What is comparison telling us?

▪ Does discrete DCF undervalue hedge fund managers?

▪ Does discrete DCF misallocates value between management and GP entities?

▪ Opportunity for discount rates re-calibration based on simulation results?

Income Approach: Strengths and Weaknesses

Discrete DCF

Strengths Issues To Consider

➢ Appraisers’ and courts’ familiarity with the method;

➢ Requires a single estimate of future annual gross investment return;

➢ Ability to capture certain assumptions, such as future capital contributions or share redemptions.

➢ Lacks flexibility to explicitly link performance and other types of risk to the enterprise value;

➢ A single estimate of future annual gross return is often too simplistic (especially in periods of economic uncertainty and market volatility).

Simulation-Enhanced DCF

Strengths Issues To Consider

➢ Provides the important flexibility to model specific risks, scenarios, and investor behavior.

➢ Can be time-consuming!

➢ Lack of broad familiarity with the method;

➢ Acceptance of the method by the courts is uncertain;

➢ Potential “garbage-in, garbage-out” problem;

➢ Inability of exact result replication and auditing.

Typical Challenges and Issues in Valuation of Hedge Funds

• Reasonable compensation for principals;

• Legal ownership v. actual allocation of economic benefits;

• Discount rate(s).

Typical Challenges and Issues in Valuation of Hedge Funds

Reasonable Compensation

• In the context of valuation, compensation of hedge fund principals presents issues that are similar to those in traditional businesses. Examples of these issues are:• Principals’ primary compensation often comes in a form of profit distributions, rather

than traditional salaries and bonuses;• When principals do receive traditional compensation, it reflects the fact that these

individuals are often “star” contributors, “faces” of the firms, and primary investment idea generators, without whom the business would not be viable;

• Principals often play multiple roles in the business, including those of portfolio managers, chief investment officers, and chief executive officers.

• Thus, normalization of reported compensation is often necessary, even when a subject of valuation is a minority interest.

• Due to secretive nature of the industry, a practical challenge is to find reliable compensation benchmarking data.

• Glocap Hedge Fund Compensation Report by HFR, Inc.:• Provides general guidelines to compensation in the hedge fund industry by

position type, experience, fund size, and fund performance;

• Not surprisingly, data indicates that compensation depends on investment performance and the size of the fund - portfolio managers’ bonus at high performing funds can be as high as 50-60% of performance fees;

• Like other studies involving hedge funds, the data may have a reporting/survivorship bias.

Reasonable Compensation:Suggested Sources of Information

• Analysis of total compensation levels at publicly traded alternative investment management and investment banking firms:• Rationale:

• Compensation of principals can be thought of as having two components: (a) market compensation for a given level of responsibility, and (b) return on owner’s capital;

• Public companies try to balance the competing needs of various stakeholder, i.e. employees and shareholders; thus, levels of total compensation in the industry may be an indication of the point of equilibrium.

• Reasonable compensation of principals can be estimated as the target total compensation based on public comps less compensation to the firm’s non-owner employees;

• CAUTION: special care must be exercised in analyzing revenue due to differences in performance fees reporting among the hedge fund managers.

Reasonable Compensation:Suggested Sources of Information

• Under typical compensation arrangements in the hedge fund industry, portfolio managers and other key employees often receive a portion of the firm’s profits;

• The effect of this industry compensation practice is that an equity interest holder in a firm may have an economic interest in the firm’s residual cash flows that is significantly different from his/her equity ownership percentage;

• Although these profit allocation arrangements are often at the discretion of the principals, they are put in place (a) to meet the competitive compensation pressure to attract and keep top talent, and (b) provide key employees with an incentive (“skin in the game”). Thus, these arrangements are driven by market forces and, in practice, management cannot eliminate them without negative consequences;

• The differences between legal ownership and actual allocation of economic benefits must be considered in valuation analysis.

Legal Ownership vs. Actual Allocation of Economic Benefits

38

Legal Ownership vs. Actual Allocation of Economic Benefits: Example

Basic Facts:

ABC Capital Partners is a hedge fund manager:

Two principals, who own the firm 50-50 (single management/GP entity);

Three portfolio managers/analysts.

To provide competitive compensation and to align portfolio managers’/ analysts’ compensation with the firm’s investment performance, the principals implemented the following profit sharing plan:

First 50% of the profits are allocated equally to the two principals;

The remaining 50% of the profit is split evenly among the principals and the three portfolio managers/analysts.

The GP entity earns a profit of $100.

Legal Ownership vs. Actual Allocation of Economic Benefits: Example

• Presence of two cash flow streams with different risk profiles (i.e. management fees and performance fees/carried interest) necessitates consideration of two discount rates;

• In general, all accepted methodologies for determining the cost of capital should be considered (e.g. “build-up” method, CAPM);

• Discount rate(s) analysis should expressly consider firm-specific risks that are typical in the industry.

Discount Rate(s)

Discount Rate(s): Consideration of Firm-Specific Risks

Firm-Specific Risk Considerations

Management Fees

Performance Fees Comments

“Key Person” Risk ■ ■Fund agreements often include special redemption clauses when a “trigger event,” such as a departure of a key person, occurs.

Performance Risk ■To earn performance fees, the fund needs to generate positive investment return, often in excess of a benchmark return or a hurdle rate.

Size of AUM ■ ■In general, smaller funds present higher risk, as they have less cushion to weather periods of poor performance.

Investor Concentration ■ ■

Investor concentration (in terms of both the number and type of investors) poses AUM retention risks.

Strategy/Sector Focus ■ ■Some hedge fund strategies may perform differently in a given economic environment. Thus, narrow strategy/ sector focus can pose an additional risk.

Questions?

Vladimir Korobov, CPA, ABV, ASA

Partner

Vladimir Korobov is a partner in the Valuation and Litigation Support Services group. He has more than 20 years of experience providingbusiness valuation, litigation support, and financial analysis services. Mr. Korobov has performed valuations of business interests for a variety ofpurposes including, but not limited to, family law matters, estate and gift tax, fairness opinions, transactions, solvency determination, employeestock ownership plan formation and updates, financial reporting, and litigation. The subjects of his valuation assignments have included entireenterprises and partial business interests, preferred and debt securities, portfolios of assets, derivative instruments, and intangible assets.

Mr. Korobov has conducted SAS 73/SAS 101 reviews of investments’ valuations for hedge funds and private equity firms and examinations ofthird-party valuation specialist reports in the context of financial statement audits. He has assisted clients in the formulation andimplementation of portfolio valuation policies, solvency analyses (including analysis of transactions in the determination of fraudulentconveyances and preferential transfers), complex business interruption claims, and investigative matters related to occupational fraud, ForeignCorrupt Practices Act (FCPA), and regulatory inquiries. Mr. Korobov’s industry experience includes, but is not limited to, traditional andalternative asset management, banking and financial services institutions, energy, pharmaceutical, petrochemical, mining, steel, manufacturing,hospitality, technology, transportation, distribution and social services.

Mr. Korobov has been qualified as an expert witness in the State Courts of Connecticut, New York, and Massachusetts, as well as variousarbitration proceedings. He has also rendered extensive services relating to court testimony.

Mr. Korobov formerly worked for a “Big 4” accounting firm in New York, in the Fraud Investigation & Dispute Services and the Valuation &Business Modeling practices.

SUBJECT MATTER EXPERTISEBusiness ValuationComplex Securities

Financial Modeling and AnalyticsLitigation Support

Matrimonial LitigationShareholder Disputes

Intangible Asset Valuation

EDUCATIONMaster of Business Administration,

FinanceUniversity of Connecticut

Bachelor of Science, Accounting, University of Bridgeport

vladimir.korobov@marcumllp.com n Phone 203.781.9785