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The Silliness of Valuing Hedge Funds

NEW YORK ( Reuters Blogs) -- How do you value a hedge fund? It's impossible, really. You can see how much it earned in any given year, but past performance is a very bad guide to future results. In any case, 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.

Partly as a result, almost nobody buys and sells stakes in hedge funds as an investment. (As Peter Lattman recalls, Anthony Scaramucci tried to do that, and failed, before he became a fund-of-funds manager.) Indeed, there are precious few hedge funds where such stakes are even traded. If you want exposure to a certain manager's alpha-generating abilities, then you're better off just investing with her and paying 2-and-20.

This is bad news for banks forced to get rid of their hedge fund arms as a result of the Volcker Rule. If they just close them down, then they'll lose money. But there also aren't willing buyers for such things out there in the world. So Citi, for one, is doing the only thing it can. It spun off Citi Capital Advisors at the beginning of March; the firm is now called Napier Park Global Capital. It's mostly owned by its managers, but Citi has retained a Volcker-compliant 25% stake, so if Napier Park does well on its own, Citi should be able to make something out of the deal.

Bloomberg's Donal Griffin is not happy about this -- not happy at all. He first wrote about the spinoff in January, when he found a hedge fund consultant, with the wonderful name of Ezra Zask, who was willing to say that Citi Capital Advisors was worth $100 million. Griffin managed to obtain "unaudited, internal CCA performance data" from the company, but he didn't reveal the contents of that data -- only that it had somehow managed to get extrapolated into the $100 million price tag.

Griffin's story appeared under the headline "The Great Citigroup Hedge Fund Giveaway", and quoted a professor at George Mason University asking why Citi wasn't selling the unit. (Griffin didn't bother to ask whether anybody on the planet would be willing to buy it, in such a deal.)

Griffin has now returned with another story on the same subject, and once again he has obtained confidential documents -- this time "internal projections" of the fees it might make in future. Those fees are incredibly uncertain, of course: they rely on the company being able to raise new money from investors, as well as outperform the markets. But guess what, here's Ezra Zask again, right at the top of the article:

Jonathan Dorfman and James O'Brien are among executives who got 75% of the investment firm for free when it broke off from Citigroup earlier this year. The business may be worth $360 million, according to hedge-fund consultant Ezra Zask.

Zask evinces no sheepishness about more than trebling his valuation for the company over the space of four months, and Griffin doesn't explain why Napier Park is worth so much more today than he thought it was worth in January. He does, however, go get a few more estimates for how much the company might be worth: One said it "could be worth as much as $300 million by 2016 if the firm replaces Citigroup's money with outside investment and attracts extra cash," while another gave a range of somewhere between $61 million and $251 million. But those estimates are much lower down in the article: Zask's highball estimate comes at the very top. And again, Griffin never bothers to explain who on earth would be willing to pay any such sum for a stake in the company.

There's a reason that you don't often see estimates for hedge funds' valuations, as opposed to their assets under management: such numbers are generally hypothetical to the point of meaninglessness. But Griffin is convinced that since Citi has given away something very valuable, something smelly must be going on here.

It's true that if Napier Park's principals manage to turn the company into a success, then they will do very well for themselves. That's the way that hedge funds work. But what I don't see is what kind of choice Citi had in the matter. It can't own the company any more, and it is being forced to withdraw the money it has invested there. So it really only had two choices: it could spin out the company, retain a minority stake, and hope that it manages to do well in the future -- or it could just close it down entirely, and suffer a substantial loss. The former is clearly the more attractive option.

If Griffin is going to write a series of articles talking about Napier Park's value, then it really does behoove him to explain what exactly he means by that. Was there a third option on the table? Could Citi have found a buyer for the business, who would have paid the bank some nine-figure sum for the privilege of owning it? If so, who might that buyer have been? And if not, in what sense do all these valuation figures mean anything at all?

Not all cash flows are created equal: An asset is worth, in the real world, only what someone else is willing to pay for it. Absent such a bidder, it seems to me that anybody talking about Napier Park's valuation should start at zero, rather than with some academic discounted-cash-flow analysis.

-- Written by Felix Salmon in New York.

Read more of Felix's blogs at Reuters.

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