The silliness of valuing hedge funds

By Felix Salmon
May 10, 2013

How do you value a hedge fund? It’s impossible, really. You can see how much it earned in any given year, but past performance is a very bad guide to future results. In any case, all future income is reliant on both the investors and the managers sticking around, which means that the value of a hedge fund to its managers is always going to be higher than the value of a hedge fund to an outside investor with little ability to keep the managers in place.

Partly as a result, almost nobody buys and sells stakes in hedge funds as an investment. (As Peter Lattman recalls, Anthony Scaramucci tried to do that, and failed, before he became a fund-of-funds manager.) Indeed, there are precious few hedge funds where such stakes are even traded. If you want exposure to a certain manager’s alpha-generating abilities, then you’re better off just investing with her and paying 2-and-20.

This is bad news for banks forced to get rid of their hedge fund arms as a result of the Volcker Rule. If they just close them down, then they’ll lose money. But there also aren’t willing buyers for such things out there in the world. So Citi, for one, is doing the only thing it can. It spun off Citi Capital Advisors at the beginning of March; the firm is now called Napier Park Global Capital. It’s mostly owned by its managers, but Citi has retained a Volcker-compliant 25% stake, so if Napier Park does well on its own, Citi should be able to make something out of the deal.

Bloomberg’s Donal Griffin is not happy about this — not happy at all. He first wrote about the spin-off in January, when he found a hedge fund consultant, with the wonderful name of Ezra Zask, who was willing to say that Citi Capital Advisors was worth $100 million. Griffin managed to obtain “unaudited, internal CCA performance data” from the company, but he didn’t reveal the contents of that data — only that it had somehow managed to get extrapolated into the $100 million price tag.

Griffin’s story appeared under the headline “The Great Citigroup Hedge Fund Giveaway”, and quoted a professor at George Mason University asking why Citi wasn’t selling the unit. (Griffin didn’t bother to ask whether anybody on the planet would be willing to buy it, in such a deal.)

Griffin has now returned with another story on the same subject, and once again he has obtained confidential documents — this time “internal projections” of the fees it might make in future. Those fees are incredibly uncertain, of course: they rely on the company being able to raise new money from investors, as well as outperform the markets. But guess what, here’s Ezra Zask again, right at the top of the article:

Jonathan Dorfman and James O’Brien are among executives who got 75 percent of the investment firm for free when it broke off from Citigroup earlier this year. The business may be worth $360 million, according to hedge-fund consultant Ezra Zask.

Zask evinces no sheepishness about more than trebling his valuation for the company over the space of four months, and Griffin doesn’t explain why Napier Park is worth so much more today than he thought it was worth in January. He does, however, go get a few more estimates for how much the company might be worth: one said it “could be worth as much as $300 million by 2016 if the firm replaces Citigroup’s money with outside investment and attracts extra cash”, while another gave a range of somewhere between $61 million and $251 million. But those estimates are much lower down in the article: Zask’s highball estimate comes at the very top. And again, Griffin never bothers to explain who on earth would be willing to pay any such sum for a stake in the company.

There’s a reason that you don’t often see estimates for hedge funds’ valuations, as opposed to their assets under management: such numbers are generally hypothetical to the point of meaninglessness. But Griffin is convinced that since Citi has given away something very valuable, something smelly must be going on here.

It’s true that if Napier Park’s principals manage to turn the company into a success, then they will do very well for themselves. That’s the way that hedge funds work. But what I don’t see is what kind of choice Citi had in the matter. It can’t own the company any more, and it is being forced to withdraw the money it has invested there. So it really only had two choices: it could spin out the company, retain a minority stake, and hope that it manages to do well in the future — or it could just close it down entirely, and suffer a substantial loss. The former is clearly the more attractive option.

If Griffin is going to write a series of articles talking about Napier Park’s value, then it really does behoove him to explain what exactly he means by that. Was there a third option on the table? Could Citi have found a buyer for the business, who would have paid the bank some nine-figure sum for the privilege of owning it? If so, who might that buyer have been? And if not, in what sense do all these valuation figures mean anything at all?

Not all cash flows are created equal: an asset is worth, in the real world, only what someone else is willing to pay for it. Absent such a bidder, it seems to me that anybody talking about Napier Park’s valuation should start at zero, rather than with some academic discounted-cash-flow analysis.

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Comments
5 comments so far

Hedge funds stakes are just like the stakes of any other private company: incredibly illiquid. While it’s worth questioning a consultant’s unjustified estimate, all anyone is going to have that is of any use is an estimate based on some DCF or what have you. Why start at zero? Absent any willing buyers, a private company – say with a real business and stable cashflows – should just be considered worthless? The private markets aren’t so efficient that there will necessarily be willing buyers of such obviously valuable businesses in all cases – and a glaringly obvious such case is that of hedge fund sponsors. This isn’t a question of the metaphysics of economic value; the question is “what is the use to anyone of defining an illiquid company as valueless until otherwise bid on?” I would suggest there’s little use…

Due to future fee uncertainty, hedge funds should be difficult to value but not impossible to. They’re going to be at most as difficult to value as a VC investment, which is essentially an OTM call option.

Posted by objectzach | Report as abusive

I read your article, “the Silliness of Valuing Hedge Funds,” with interest. However, I was disappointed that it did not take the question of hedge fund valuation beyond “silly.” With the increased consolidation in the hedge fund industry, the issue is increasingly important.
I would argue that your article should have been titled “the Complexity of Valuing Hedge Funds.” I published in the Journal of Alternative Investments in 2000, “Hedge Funds: A Methodology for Hedge Fund Valuation,” which was based on my experience working for an M&A firm that specialized in the valuation of financial firms, including hedge funds. The article points out the complexity of valuing hedge funds, but also offers a framework for valuation. I recently wrote an update this article, “Trends in Hedge Fund M&A and Valuation: 2000-2013” which is available on my company’s website (www.sfcassociates.com). This article documents 28 M&A transactions since 2006 that involved alternative investment firms. My analysis reports the value of each deal and shows this value as a percentage of the acquired firms’ assets under management (the only publicly available metric).
The acquiring firms include Carlyle Group, Man Group, Royal Bank of Canada, JP Morgan, Credit Suisse, Bank of China, Mitsubishi Corporation, Blackstone Group, Morgan Stanley, Bank of Ireland, and Dubai International Corporation. I would have to assume that these firms did a valuation of the acquired hedge fund before spending billions of dollars. Indeed, Citigroup purchased a hedge fund, Old Lane Partners, in 2007 for $800 million. I am sure Citigroup would be astounded to learn that they had spent nearly a billion dollars on the basis of a “silly” valuation of the fund.
In valuing Napier Park Global Capital I used two standard, well-established methodologies – discounted cash flow and the hedge fund industry’s average AUM multiple. I believe that the issue of hedge fund valuations, while extremely complex, is far from “silly” and deserves a serious discussion. I recently published a book for McGraw Hill, “All About Hedge Funds, Second Edition” (2013) which I believe contributes to this discussion. (www.allabouthedgefunds.com)

Posted by ezrazask | Report as abusive

“Indeed, Citigroup purchased a hedge fund, Old Lane Partners, in 2007 for $800 million. I am sure Citigroup would be astounded to learn that they had spent nearly a billion dollars on the basis of a “silly” valuation of the fund.”

This example considerably undermines the rest of the case.

Posted by dsquared | Report as abusive

@dsquared: That doesn’t undermine his argument. The point is not whether Citi got a good deal when it bought Old Lane (Citi shareholders certainly wouldn’t think so). The point is that banks, and other large asset managers routinely buy hedge funds, and stakes in hedge funds, and that requires them to value those funds before making that purchase. Take for example DYAL Capital, an offshoot of Neuberger Berman; all they do is take PE stakes in hedge fund managers. Do you think they commit serious capital without applying a rigorous valuation process? Whether or not Felix Salmon thinks that the process of valuing hedge funds is “silly,” the fact remains that in the past few years, M&A activity in the hedge fund space has been accelerating, and the valuation of hedge fund managers- as tricky as that process may be- has been a regular part of the M&A process.

Posted by PLSD | Report as abusive

@dsquared, the point is not whether Citi got a good deal when it bought Old Lane- most Citi shareholders would argue that it didn’t. The point is that major banks and asset managers are actively involved in a growing hedge fund M&A environment, and those professional investors do not make M&A decisions with extensively modeling out the target firm’s valuation. Period. Salmon may think this exercise silly- it is in fact difficult to value the OTM call option component of future performance fees- but its what firms are doing every day. Look at DYAL Capital, a spin out of Neuberger Berman, which focuses on buying stakes in hedge fund sponsors. Look at seed capital providers like RMF/MAN- they are making valuation calculations when they take equity stakes in emerging managers.

Posted by PLSD | Report as abusive
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