In a dispute arising over a hedge fund failure, Cornerstone Research was asked to value the firm that managed the fund and to assess how the firm’s value was affected by the fund’s performance. Cornerstone Research worked with a prominent finance professor to develop and apply a methodology to value the management firm given the contracts between the firm and its investors.
Option pricing theory provided the framework for estimating the value of investments in the firm.
The value of a hedge fund management enterprise is based on its expected flow of fund management and incentive fees. Noting that the payoff from the flow of fees is analogous to a payoff of an option contract, we developed an option pricing framework to calculate the present discounted value of expected fees. Because fees also depend on the size of the assets being managed, we used a regression model to predict the net flow of assets into the fund. The model relied on a large sample of hedge fund performance data and predicted fund flow as a function of the fund’s past performance, size, age, investment strategy, and other variables.
Valuing the firm also required assessing its capital structure, which included several classes of privately issued equity and debt governed by contracts involving complex contingent claims. The realized value of investments in the managing firm depended, for example, on contingencies related to the firm’s potential default on debt repayments and options to convert debt to equity. Realization of these contingencies depended on, among other things, the performance of the fund and the management firm. Again, option pricing theory provided the framework for estimating the value of investments in the firm.
