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On the Valuation of Hedge Funds (or Hedge Fund Managers)

posted by Stephen Lubben

So Felix Salmon has taken a justifiable swipe at some oddish Bloomberg articles on Citibank's spinoff of its internal hedge fund, as required by the Volcker Rule.

But in doing so, it seems as though he may have hit his own wicket.  (OK, I'll admit to wishing I was here, rather than grading Con Law exams).

For example, he argues that "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."

First off, I assume he is referring to the manager, rather than the fund itself. And if value is reliant on the managers sticking around – why is a hedge fund that much different than any other company? Even a company with a large amount of fixed assets depends on the quality of its management to give those assets real value (e.g., GM) and companies with slight physical assets don't disappear when a key manager departs (e.g., Apple).

He also says "almost nobody buys and sells stakes in hedge funds as an investment" and thus suggests that hedge fund "valuation should start at zero, rather than with some academic discounted-cash-flow analysis."

Well there is the case of Och-ZIff, a publicly traded hedge fund manager. Its outside shareholders do seem to think that there is some value in the future cashflows there, despite the fact that the managers might up and leave at a moment's notice. Either that or investors are buying the stock regardless of price. That seems likely.


Two points:
1. Hedge funds are rather different than Consolidated Widget. Their managers have very little firm-specific human capital, although they may have some team-specific human capital. This makes them much more volatile. Silicon Valley has the same problem. So do the New York Yankees.
2. There is a traditional way of handling this problem, if a firm don't have an antitrust exemption: deferred comp.

Of course there is always intangible asset valuation. For example, hedge funds such as Blackstone have brand equity that at least in theory commands a premium.

Also, not all hedge funds necessarily have a management problem. To illustrate, hedge funds that have an investment mandate irrespective of who carries it out place emphasis on the fund's legacy, rather than the management itself.

Additionally, hedge funds that consistently outperform the market in carrying out investment strategy such as relative-value arbitrage, exhibit the strength of a fund's managerial objectives and policies. This is especially the case if the fund meets benchmarks despite having had numerous managers.

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