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Money managers under the microscope

Neil Campbell: Valuations in the hedge fund secondary market

March 16, 2011

Guest blogger Neil Campbell is head of Tullett Prebon Alternative Investments.

The views expressed here are entirely the author’s own and do not constitute Reuters point of view.

The central aspect of the burgeoning illiquid hedge fund secondary market is asset valuation. But what should drive secondary pricing — the market valuation/sentiment, i.e. the price that the market will pay for these assets today, or the manager’s internal valuation?

Over the past year, we at Tullett Prebon Alternative Investments have seen the spread on a big number of illiquid funds narrow considerably. As a result, there is now much greater transaction volume. But in some case there are still sizable disparities between buyer and seller valuations.

Sellers will typically rely on hedge fund GPs’ (general partners’) valuations of portfolio assets. It is hard for a seller to justify selling its shares at steep discounts when they are receiving a rosy outlook from the GP.  But how reliable are these GP valuations and liquidity timelines?   How relevant is a GP’s valuation of an asset that they won’t sell because they believe the market for it is too low?  Or should a listed security that trades once in a blue moon be valued at par?

Ironically, as potential buyers and sellers strive to ascertain accurate discount levels at the LP (limited partnership) level, we are seeing fund managers contemplating selling their own illiquid assets in direct secondary markets occasionally at steep discounts to NAV.

This requires greater sophistication and diligence on the part of buyers to gauge what the ultimate recovery value of these vehicles will be.

This presents a challenge for secondary LP buyers; while they may have fundamental interest in underlying fund assets, their valuations or liquidity assessments may not always match GP/LP expectations. Due to the lack of transparency and the inherent uncertainty regarding liquidity timelines, buyers will typically build in a bigger discount, which may be unpalatable for prospective sellers.

So the only relevant valuation of an asset in the context of an increasingly active secondary sphere has to be that of market sentiment.  For what good is a GP’s valuation if the market is willing to pay only a fraction of it?

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