Saturday Brain Storming Thought (150) 29/01/20211


Hedge fund is a private investment partnership and funds pool that uses varied and complex proprietary strategies and invests or trades in complex products, including listed or unlisted derivatives

Meaning of Hedge Fund

A hedge fund is a investment vehicle that creates to high-net-worth individuals, institutional investors, and other accredated investors

The term hedge is used because these funds historically focused on hedging risk by simultaneously buying and shorting assets in a long-short equity strategy

Today’s hedge funds offers a very wide range of strategies across practically all available asset classes, including real estate, derivatives and non-traditional investments such as fine art and wine

Many use leverage strategies, meaning they borrow money in order to boost their potential returns

Current Industry Trends

1) Reconsideration of hedge funds as an asset class by institutional investors

2) industry is still growing, but larger, more established funds tend to benefit from growth

3) significant pressure on fees – traditional “2-20” structure no longer works

4) wider acceptance of benchmarks and hurdle rates in measuring performance

5) Regulations

6) Re-emergence of investors in hedge fund management firmd

Traditional 2/20 Fee Structure

In hedge fund industry it refers to 2% of annual management fee and additional 20% incentive fee on investors net profit

Typical Hedge fund fee structure

According to HFR, in the fourth quarter of 2020, hedge funds charged an average of a 1.4% management fee and 16.4% performance fee

Value creation by hedge funds

Hedge funds can create a lot of value by bringing perception and reality closer together

Areas of Valuation

1) Tax
Gift/Estate planning/compliance

2) Transactions
Equity grants to key employees / admission of new partners, investments in management and/or GP entities by third parties

3) Financial reporting
Determination of fair value of illiquid/private investments

4) Litigation
Martial dissolution, business disputes

Meaning of GP entities

GP entities means each person that is the general partner or managing member (or equivalent) of any enhanced fund including, without limitation, enhanced small business investment company GP, LLC

Typical Challanges and issues in valuation of hedge funds

1) Reasonable compensation for principals

2) legal ownership vs actual allocation of economic benefits

3) discount rates

Reasonable Compensation

1) Principals primary compensation often comes in a form of profit distributions, rather than traditional salaries and bonuses

2) these individuals are often star contributors, faces of the firm’s, and primary investment idea generators, without whom the business would not be viable

3) principals often play multiple role in the business, including those of portfolio managers, chief investment officers, and chief executive officers

4) normalization of reported compensation is often necessary, even when a subject of valuation is a minority interest

5) due to secretive nature of the industry, a practical Challange is to find reliable compensation benchmarking data

6) special care must be exercised in analyzing revenue due to differences in performance fees reporting among the hedge fund managers

7) reasonable compensation of principals can be estimated as the target total compensation based on public compensation less compensation to the firm’s non-owner employees

Legal ownership Vs actual allocation of economic benefits

1) portfolio managers and other key employees often receive a portion of the firm’s profit

2) the effect of this industry compensation practice is that an equity interest holder in a firm may have an economic interest in the firm’s residual cash flows that is significantly different from his/her equity ownership percentage

3) profit allocation arrangements are driven by market forces and in practice, management cannot eliminate them without negative consequences

4) the differences between legal ownership and actual allocation of economic benefits must be considered in valuation analysis

Discount rates

1) presence of two cash flow streams with different risk profiles (ie management fees and performance fees/carried interest) necessitates consideration of two discount rates

2) in general, all accepted methodologies for determining the cost of capital should be considered (eg build-up method, CAPM)

3) discount rates analysis Shoukd expressly consider firm-specific risks that are typical in the industry

Types of Hedge Funds

1) even driven strategies such as mergers, acquisitions and bankruptcies create a lot of movement in the stock market

2) Equity Arbitrage

3) Mortgage arbitrage

4) funds of funds

5) emerging markets

6) Global funds

7) selecting a fund

Precautions to be taken while investing in hedge funds

1) be an accredited investor ie having a minimum level of income or assets, to invest in hedge funds

2) read a funds prospectus and related material is higher risk – higher potential returns

3) understand fees which impact your return on investment

4) understand any limitations on your right to redeem your shares

5) research hedge fund managers

6) understand how fund assets are valued

7) ask questions because you are entrusting your money to someone else

Benefits of Hedge Funds

1) a wide choice of investment strategies

2) the potential to generate positive returns in both rising and falling equity/bond markets

3) can play a part in diversifying a balanced investment portfolio

4) access to some of the world’s most talented investment managers

5) flexibility compared to mutual funds

6) increases the chance of diversification

7) experts advice and transperancy

Disadvantages of Hedge Funds

1) dependence on the investment decisions of the fund manager

2) concentrated investment strategies can expose funds to potentially huge losses

3) typically lower level of liquidity compared to mutual funds

4) your money may be locked up for years

5) hedge fund fees

6) it measures the volatility of possible gains

Most famous hedge funds

1) Bridgewater associates

2) Renaissance technologies

3) Man group

4) Elliott management

5) Two sigma investments

6) Millennium management

7) Davidson Kempner capital management

8) Citadel advisors

Most popular Hedge Fund stocks

1) Apple Inc (AAPL)

2) Microsoft Corp (MSFT)

3) (AMZN)

4) Alphabet Inc (GOOG)

5) American Express Company (AXP)

6) Facebook Inc

7) Ban of America Corp

8) Visa Inc

9) The Coca-Cola company

10) Charter communications Inc (CHTR)

Valuation of Hedge Funds

Within the Income Approach, PE carried interests are typically valued in two ways

1) Discounted Cash Flow (DCF) method

2) Option Pricing method
For Hedge Funds, GP interests that receive performance fees are generally valued using DCF method

Hedge Funds are required to place a value on their assets on a periodic basis (offer quarterly)

NAV for Hedge Funds

Net asset value = Total Asset value – Total liabilities

Higher NAV generally suggests that the scheme has prospered well in the past or has been around for a long time

Key Takeaways of Hedge Funds

1) hedge fund is often a limited partnership or LLC that pools money from investors to invest in high-risk securities and other assets

2) these funds are limited to accredited investors, who must meet stringent financial requirements that have significant assets, due to their high fees and the investment risk involved

3) Hedge managers are paid based on funds profit, which encourages them to take risks to earn more

4) Hedge funds specialize in investing in securities, businesses, junk bonds, real estate ie even patents and music copyrights

Hedge Funds in Real Estate

Real estate hedge funds tend to invest in publicly-traded real estate companies, mostly real estate investment trusts (REITs)

Big investment companies have pooled in and they are acquiring properties, different things and essentially making money

These hedge funds are buying homes, splitting them into multiple-family apartments, and renting them for a raised price

For this reason, home buyers are at a disadvantage

Parker says that hedge funds come with cash in hand and buy houses quickly while homebuyers have less money and it takes longer

Compiled by:-

Er. Avinash Kulkarni
Chartered Engineer, Govt Regd Valuer, IBBI Regd Valuer

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