We Need Hedge Fund Valuations Now More Than Ever

by: Susan Mangiero, CFA

A key element of any valuation engagement is an assessment of "premise of value." Said another way, an appraiser must determine whether an economic entity is likely to remain in business (and therefore should be treated as an ongoing concern) or instead be put in the "not going to make it" bucket. If operations are thought to soon cease, imminent liquidation is almost sure to follow, (wherein the business sells assets and tries to make good on outstanding obligations, to the extent that proceeds are available.) According to a recent article, the "alive or dead" litmus test may be needed now, more than ever before.

CNNMoney.com reporter Ben Rooney cites a recent Hedge Fund Research study that documents 344 liquidations or "more than three times the 105 liquidations in the third quarter of 2007" or "77 more than the previous record of 267 liquidations in the fourth quarter of 2006." On an annual basis, failed hedge funds may reach nearly 1,000 for the full year or more than "the previous record of 848 of 2005." (See "Hedge fund graveyard: 693 and counting," December 18, 2008.)

Redemptions, wild market swings and idle cash, sitting on the sidelines, are a few likely culprits with respect to which hedge funds survive or fail. What this means to institutional investors is profound. Due diligence must address whether and for how long a particular hedge fund might be expected to be a viable commercial enterprise (and so much more). Without stating the obvious, who wants to plunk down good monies for a fund that has a low probability of being around for the foreseeable future?

In a related article, Financial Times reporter James Mackintosh reports that Switzerland's Union Bancaire Privée has told "managers of the $56bn it has allocated to hedge funds to put in immediate redemptions for any fund that does not have independent administrators and custodians." The article goes on to say that some hedge fund notables are on the redeem list while others have decided to appoint independent third parties. (See "Investor demands fund checks," December 23, 2008.)

Anecdotally, I've heard that institutional investors (either through the audit or compliance functions or both) are requiring more documentation (read "transparency") from their hedge fund managers. To date, they say they have had little push-back. One wonders if there is a balance of power shift underway, favoring institutional investors. After all, how many of us have heard some asset managers decline (sometimes vehemently so) to implement what they deem to be expensive and time-consuming procedures UNLESS pensions, endowments and foundations demand such?

Note: Valuation of a hedge fund as a business is not the same thing as assessing the worth of instruments inside the hedge fund's portfolio. Consider a particular hedge fund that successfully invests in distressed securities.