There has been a lot of discussion and regulatory effort of late in relation to the performance of hedge funds and the reported market value of their illiquid investments. Regulators and auditors want hedge funds to mark investments at fair market value on a regular basis, at least quarterly, if not monthly, and investors want to make sure that fund managers are not marking investments incorrectly. Furthermore, pro-active managers and boards of directors of hedge funds want to assure investors, especially institutional clients, that they are precautious and doing everything in their power to stay far from potential scandal. However, just because hedge funds invest in illiquid investments need not mean that the pricing of these investments has to be guesswork or left to the willies of fund managers who may be swayed to mark illiquid investments upward in order to garner large performance fees.
To satisfy regulators, auditors, investors, and boards of directors, hedge funds are turning to third party valuation services for “Opinions” that confirm the fair market values of their illiquid investments. The valuation service providers are typically dedicated valuations firms, mid-sized investment banks, accounting firms or business/management consulting companies. There is even a movement among investment banks, accounting and consulting firms to spin off their valuation groups, so that there are no conflicts of interest with the firm’s other businesses.
Valuation opinions for illiquid investments are similar to traditional Fairness Opinions that provide or opine on a fair market value of a buyer or target in an M&A transaction, the fair market value of a company going private, or the fair market value of a company with regard to an ESOP or PIPE transaction. While traditional Fairness Opinions can take weeks or months to produce, at a cost of tens or hundreds of thousands of dollars, valuation opinions for illiquid investments typically take only several days to produce - the first time - and up to a day or two to update every month or quarter. Since the valuation service providers mark to market portfolios of illiquid hedge fund investments on a monthly or quarterly basis, the fees (several thousand dollars for each individual investment) can become quite substantial, depending on the size of the portfolio. However, these fees can be perceived as relatively minor when compared to the cost of not using a third party valuation service and potentially being subject to investigations, fines, law suits and lost institutional business. Valuations of illiquid investments are also given on a one-time basis, typically to establish a fair transfer price among the various entities of a large hedge fund, such as between an on-shore and offshore entity.
The various types of illiquid investments that are valued include, but are not limited to, first and second lien bank loans, real-estate holdings and developments, aircraft and aircraft engines, oil and gas royalties, movie production and distribution companies, bonds and equity of impaired companies, CLOs and CDOs, and equity in hi-tech start-ups.
The valuation service providers use various methodologies to value their clients’ investments. “Should we mark it at the bid, the offer, or in-between?” Actually, portfolio valuation is a bit more sophisticated than that, because generally, there is no bid, offer or in-between. To value illiquid investments, the service providers use a tool-box of well-tested and generally accepted valuation methodologies, including discount cash flow analysis (DCF), weighted average cost of capital (WACC), comparable EBITDA and revenue multiples of public companies, comparable transaction prices and multiples in private transactions, comparable financial instruments and spreads, Black-Scholes modeling (for options and warrants), fundamental financial analysis, leverage ratios and loan to value. Sometimes, they have to decipher the legal proceedings of bankruptcies to estimate the probable resolution of claims. On those occasions, it helps that some (investment-banking) days have at least 36 hours each – or does it?
It does. At an investment bank, every month, my colleagues and I had to value an equity investment in a private company, and we steadily marked the value upward over the course of a year due rising EBITDA multiples of comparable companies. We may have been taken by surprise when the company was bought – but not by the purchase price. We were close to the mark (it helps that we typically gave a range for equity values). For another investment, in a company involved in bankruptcy proceedings, our estimated fair market value for the investment based on estimated probabilities of recoveries came very close to the actual recoveries made by our client, a hedge fund, when the impaired company emerged from bankruptcy.
Many of the investments I have valued are bank loans, and many are priced at par (100%) – or at a slight discount to par (typically 98% to 99.75%) due to the fees and/or penny warrants received by the Lender hedge fund when the loan was made. However, at times, my colleagues and I noted that a Lender hedge fund was receiving an extremely high interest rate relative to the risk it was taking as measured by the Borrower’s financial performance, leverage ratio and/or loan to value. When there was a pre-payment penalty if the loan was pre-paid early, we marked the loan above par (specifically, at par plus the pre-payment penalty), if we thought the Borrower would refinance and prepay early (better to pay the pre-payment penalty once than the high interest rate until maturity). The flack we got from the clients for marking bank loans above par – and the apologies we got when the loan was subsequently repaid early at 101% or 102% due to the pre-payment penalty!
Some of the portfolios on which I have worked have had only a few investments that require quarterly valuations, but one large portfolio had approximately three dozen investments that required valuations each and every month. Much of the fun of doing portfolio valuations is analyzing in various ways so many different types of investments in so many different types of companies. Throw in the multitude of styles in which companies present income statements, balance sheets and cash flow statements – and the fair market value of each illiquid investment becomes a challenging puzzle to solve – but need not be a mystery for the regulator, auditor, hedge fund director or investor.