ARTICLE FROM THE MARCH 2007 EDITION OF THE MATRIMONIAL STRATEGIST
Reprinted with permission from the March 2007 edition of the ‘Matrimonial Strategist’ © 2007 ALM media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, firstname.lastname@example.org or visit www.almreprints.com.
By: Glenn S. Liebman, CPA/ABV
Determining the value of a hedge fund investment is completely different from and far more complex than the relatively straightforward way of determining the value of shares of a publicly traded stock. During the past 10 years, the explosive growth of the hedge fund industry has made the analysis of hedge fund investments and hedge fund businesses an increasingly common part of the financial due diligence necessary in matrimonial cases.
According to the Center for International Securities and Derivatives Markets, in the five-year period from year-end 2000 through year-end 2005, the number of hedge funds more than doubled from approximately 3300 to over 6700. Furthermore, the number of assets managed by hedge funds during this period has tripled from approximately $400 billion to over $1.2 trillion (“The Benefits of Hedge Funds: 2006 Update”, CISDM Research Department). Under the U.S. Securities Act of 1933, only accredited investors may invest in hedge funds. An accredited investor is defined as either a high net worth individual with an annual income of at least $200,000 or a net worth of at least $1 million, or a corporation, partnership, LLC, business trust or taxexempt organization not formed for the purpose of investing in hedge funds and with total assets in excess of $5 million. Matrimonial attorneys should identify whether either or both of the parties have an investment in a hedge fund, or if either of the parties have an ownership interest in a business that operates a hedge fund.
DEFINITION OF A HEDGE FUND
The U.S Securities and Exchange Commission (SEC) has defined a hedge fund as an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which are not registered as an investment company under the Investment Company Act (“Implications of the Growth of Hedge Funds”, Staff Report to the United States Securities and Exchange Commission, September 2003).
Hedge Fund managers can utilize many different types of assets such as equities, debt, convertible instruments, futures and commodities. The choice of type of asset is generally dependent on the expertise of the manager and the investment objective of the fund. Many hedge funds seek to reduce risk by employing “hedging” strategies such as shorting stocks and using derivatives to counteract market downturns, though not always successfully. Unlike mutual funds, hedge funds are generally not required to file with the SEC. Consequently, if one of the parties in a divorce action has investments in hedge funds or owns and operates a hedge fund, due diligence should be considered by the matrimonial practitioner in order to value such investments properly.
HEDGE FUND MANAGER COMPENSATION
Hedge Fund managers generally receive two forms of compensation. The first is a management advisory fee, which is generally computed at an annual rate of 1% to 2% of assets under management. The management fee may be paid by investors on a monthly or quarterly basis, depending upon the agreement with the hedge fund manager. The second fee is known as an incentive fee or performance allocation. This fee is generally calculated at year’s end. The hedge fund manager typically receives an allocation equal to 10% to 20% of the positive return or appreciation of the assets under management. If there is no positive appreciation on the assets managed, then the hedge fund manager does not receive an incentive fee. Often, the hedge fund managers set a certain benchmark (e.g., the performance of the S&P 500) that must be exceeded in order for the hedge fund manager to receive an incentive fee. This benchmark is commonly known in the industry as the “hurdle rate.” Generally, if the hedge fund sustains a down year, then in subsequent years the fund must recover its losses and then achieve appreciation in the fund in order to earn the incentive fee. The amount of losses that must be recouped before the incentive allocation is earned is known in the industry as the “high water mark.”
HEDGE FUND STRUCTURES
Hedge Funds may be set up in a complex manner involving a variety of entity vehicles. Generally, an entity is established to serve as the management company or advisory company, which collects the 1% to 2 % annual management advisory fee. This entity can be established as a limited liability company (LLC), SCorporation, or general or limited partnership. Ordinarily, the management company pays the general overhead of the business, including the salaries of the employees and the business owners.
Hedge funds may manage separate accounts on a client-by-client basis, or in many instances, client funds are pooled into a limited partnership for common investment. It is these limited partnerships that serve as the actual fund where the client funds are held and invested by the management advisory company. Hence, one of the expenses of the fund is the management advisory fee that is paid to the management advisory company. Generally, there is an agreement between the limited partnership and the management advisory company that outlines, among other provisions, the nature of the fee and payment terms.
Many hedge funds provide service to foreign investors. Often a counterpart off-shore fund is set up to mimic the structure of the domestic fund. The management advisory company is compensated in the same manner, i.e., a 1% to 2% annual management fee, plus a 10% to 20% incentive fee on the appreciation of assets. With respect to the incentive fee, it is often the case that the hedge fund manager may defer this portion of compensation for a period of years for tax purposes. This is an asset that on the surface may be difficult to detect; nonetheless, the matrimonial practitioner should inquire about the existence and magnitude of this asset.
It is not uncommon that the owner or owners of the management company are also limited partners of the limited partnership with their own personal funds invested in the fund. This may be done in an effort to establish confidence with potential investors that the fund manager is willing to invest his own assets in the fund that he will be managing. With larger hedge fund businesses, there may be multiple limited partnerships (i.e., funds) managed by the management advisory company. Generally, new funds are established based on different investment criteria.
Additionally, there is a general partner of the limited partnership. The general partner is frequently established as a separate legal entity such as a limited liability company that is owned by the same individual or individuals who own the management advisory company. The general partner tends to be the entity that receives the 10% to 20% incentive fee on the appreciation of the fund (although there are situations when an entirely separate entity is established for this purpose).
Various valuation issues may need to be explored with respect to hedge funds. If one of the parties to a matrimonial action is a limited partner in a Hedge Fund, then financial statements of the limited partnership should be obtained, as well as schedule K-1s that the investor will receive at each year end. Furthermore, some funds may provide investors with quarterly reports and statements indicating fund performance and the value of the investor’s individual interest in the fund.
Of key importance in the discovery process is to ascertain whether or not the assets of the fund are valued at fair market value for financial statement and tax purposes. Many funds have their financial statements audited, and in conjunction with the audit, the securities held by the fund are frequently stated at fair market value or fair value. Many fund managers use fair value and leave the subject of discounting to the limited partners’ financial advisers.
If one of the spouses in a matrimonial action is an owner of a hedge fund, a variety of valuation issues will arise. First, the management company will need to be valued. Traditional valuation approaches would be considered to value the management company. It is generally very difficult to obtain data on transactions of hedge companies because most hedge fund businesses are private and do not release financial data to the public. As a result, a market-based approach involving a comparison of the subject hedge fund to hedge fund businesses that have been bought and sold is generally not employed.
Alternatively, an income approach will generally be utilized. An income approach will involve a determination of the future-expected earnings of the management company. Earnings of the management company are predicated on the assets under management. Therefore, a careful analysis of the management company’s historical trend in assets-under-management is necessary. Once future-expected earnings are determined, they are capitalized at a multiple commensurate with the risk associated with the income stream. Some factors to consider in determining the risk level of the future expected earnings are the type of assets managed, volatility of inflows and outflows of fund investments, key management personnel, and concentration of the fund assets from one client or a small number of clients.
The entity receiving the incentive fees will be valued in a similar manner. However, since the incentive fee is contingent on positive fund performance as compared to the management fee that is earned, whether or not the fund returns are positive or negative, the risk associated with the incentive fee tends to be greater. As a result, the multiples applied to the future expected incentive fee are generally lower than the multiples applied to the management fees.
The analysis and valuation of hedge fund investments and hedge fund ownership interests is complex and requires a thorough understanding of the entity and legal structure. Furthermore, numerous types of interests may need to be analyzed and valued within the context of a matrimonial action. For this reason, the matrimonial practitioner should consider hiring a financial expert experienced in valuing these types of entities to assist in the discovery, due diligence and valuation phase when the issue of a hedge fund interest or investment arises.
Glenn S. Liebman, CPA/ABV, is a member of Klein, Liebman & Gresen, LLC, a business valuation and forensic accounting firm located in Woodbury, NY. Mr. Liebman has valued several hundred businesses over the past ten years. He frequently speaks to bar associations on the topics of business valuation and forensic accounting, and serves as an expert witness.