Seed Investing Series:

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1 Seed Investing Series: Valuation considerations for seed investors and strategic minority interests in investment fund complexes By Jesse Shapiro, Stephan Thollot and Chintan Muchhala, Ernst & Young LLP

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3 This is the second in a series of articles that cover various aspects of investing in seeded and minority investments in investment management entities of hedge funds and other alternative investment vehicles (collectively, investment funds). Our previous article, Seeding investment structures and their US tax considerations, covered different types of seed arrangements and their tax implications. It highlighted the fact that the combination of the credit crisis and an enhanced regulatory environment has created a heightened sense of risk aversion on the part of traditional investors in investment funds. As more talented investment professionals look to launch their own alternative investment management firms, they have found that this new environment has created a rift between supply and demand for start-up capital. As a result, there has been a rise in seeding activity, whereby investors (seed investors or seeders) provide these emerging managers with initial capital infusions in exchange for a series of exclusive rights, ranging from reduced fees to profit sharing in management and incentive fees. Similar to seeders, investment funds and large institutional investors are acquiring minority interests in investment managers who are seeking strategic partners to enter the next phase of their growth life cycle. These strategic minority investors often bring access to institutional capital, operational expertise and infrastructure to help these investment managers on their path to institutionalization. The structure of minority investments often takes similar forms to traditional seed investments. The valuation considerations in this article are common to seeders and strategic minority investors. Fair value under US GAAP As we covered in our last article in the series, seeders typically provide start-up equity directly to an investment fund as a form of passive investment in exchange for reduced fees, favorable terms or both. In other types of seed deals, this equity may come in the form of a special limited partner interest that receives a portion of the incentive fees and/or management fees allocated directly to its capital in the underlying fund. Further, seeded investments in start-up funds may also include an investment in the equity, or a profits interest, in the associated advisor and investment management vehicles of the start-up fund. The estimation of fair value of a seeder s investments in the underlying funds or in the investment management vehicles is an important component of the seed business, whether for financial reporting purposes, strategic transactions or investment monitoring. Seeders, depending on the type of entity (e.g., an investment company/ fund), may be required under US generally accepted accounting principles (US GAAP) to report the fair value of financial assets and liabilities in their financial statements. This is especially true for those seeders who are subject to the provisions of Accounting Standards Codification (ASC) 820, Fair Value Measurement (ASC 820). Although this article focuses on seeders who are subject to ASC 820 under US GAAP and are thus required to determine the fair value of their interests, the valuation concepts covered here can be applied to other situations, such as for strategic transactions. It is a common misconception that seeders subject to ASC 820 do not have to perform a fair value analysis for financial reporting purposes if the seeded investments are held in a side pocket or direct investment account or if the legal agreement of the seeder states that the profits and losses allocated among the seeder s investors are based upon the cost basis, or purchase amount, of the seeded investment. Defaulting to the amount of equity invested as an indication of fair value may also not be appropriate without a proper fair value analysis to support it. ASC 820 applies to a seeder s investments for financial reporting irrespective of these notions. Fair value is defined under ASC 820 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is a market-based measurement, not an entity-specific measurement and, as such, is determined based on the assumptions that market participants would use in pricing the asset or liability. For investments where there is no readily available market, the transaction to sell the asset or transfer the liability is a hypothetical transaction as of the measurement date and assumes an appropriate period of exposure to the market, such that the transaction is considered orderly. The exit price objective of a fair value measurement applies regardless of the reporting entity s intent and/or ability to sell the asset or transfer the liability at the measurement date. In addition, a fair value measurement contemplates the sale of an asset or transfer of a liability, not a transaction to offset the risks associated with an asset or liability. Seed Investing Series 2

4 Valuation of investments in underlying seeded funds A seeder s investment directly in an underlying seeded fund is generally permitted to be valued using the underlying seeded fund s net asset value (NAV) as of the seeder s reporting date. This is known as the practical expedient under ASC 820. In order to qualify for use of the practical expedient, the NAV of the underlying seeded fund must be determined using the fair value principles of US GAAP. Other bases of accounting, such as International Financial Reporting Standards, may be used to compute the NAV, so long as they follow substantially the same valuation principles as US GAAP. There are, however, some exceptions to the use of the practical expedient. If, as of the reporting date, it is probable that the seeder will sell its investment in the seeded fund for an amount that differs from the NAV at that date, then use of the practical expedient is not permitted. One example is when it is determined by the seeder that the NAV is not computed using US GAAP valuation principles. Another example is when the seeder determines that it does not agree with the computation of the seeded fund s NAV, whether due to the fact that the seeder has transparency into the seeded fund s underlying investments or the seeder has considered that there are other facts and circumstances that make its interest unique, such as special limited partner interests, long-term lockups, suspended redemptions and so on. In these situations, the seeder may need to consider whether adjustments to the NAV may be appropriate or whether they need to apply one of the fair value methods described later in this article. Valuation of investments in seeded management entities In addition to having equity invested in the underlying seeded funds, seeders often make equity investments or take profit shares in the associated investment advisor, general partner or management company entities (individually, an investment management entity or IME). As IMEs are generally not considered investment companies under US GAAP, use of the practical expedient for valuing interests in IMEs likely would not be appropriate. Other valuation modeling techniques as described later in this article are more commonly employed for IME interests. ASC 820 states that it is best practice to employ and triangulate multiple valuation techniques, when such techniques are appropriate and available, in estimating the fair value of an investment. ASC 820 states that valuation methods fall under different categories, including the market approach and the income approach. The market approach is defined by ASC 820 as an approach that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business. The income approach is defined by ASC 820 as an approach that converts future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. When the income approach is used, the fair value measurement reflects expectations about those future amounts. There are several valuation methods that are typically applied in estimating the fair value of a seeder s interests in an IME. Typically, the IMEs are organized separately as management companies and general partner entities. The management companies typically earn the management fees and bear the majority of the operational expenses that are incurred. The general partner entities typically earn the incentive fee/allocations, which is based on a percentage of the profits of the underlying seeded funds. Therefore, if organized separately and if the earnings are distributed independent of each other, it is important to value these entities separately. Estimating the fair value of IMEs in the initial years (i.e., start-up phase) will involve more elements of subjectivity and will require making several key assumptions and inputs that may not be readily observable. In the start-up phase, a discounted cash flow (DCF) analysis is generally employed to estimate the fair value of IMEs. As the entity matures and grows its external capital base, market approaches can be employed such as using a revenue multiple or assets under management (AUM) multiple that can be derived from comparable publicly trading investment management firms. The multiples derived from publicly trading investment firms are typically discounted for illiquidity and size of IMEs. In some cases, if such multiples are available for comparable private transactions, those may also be used in developing an estimate of fair value. 3 Seed Investing Series

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6 It is a common misconception that seeders subject to ASC 820 do not have to fair value seeded investments that are held in a side pocket or if the legal agreement of the seeder states that the seed investment shall be held at its cost basis. The DCF analysis under ASC 820 is considered an income approach whereby the fair value of an IME would be estimated by present valuing its free cash flows (i.e., amount of management and incentive fees less its operating expenses), expected to be generated by the IME over a discrete period of time (e.g., 5 or 10 years) and determining a terminal or perpetuity value (i.e., the value of the IME s cash flows for periods beyond the discrete period of cash flows used in the DCF). Expected cash flows of an IME are generally derived using expected annual returns and expected AUM growth of the funds it manages and the incentive and management fee rates for those funds. The incentive and management fee cash flows should be separately developed and the value of each of those income streams should be developed separately. Expected annual returns of the seeded funds can generally be derived from market-based indices specific to the funds strategy and are typically adjusted by taking into account various factors, including, but not limited to, any available historic returns of the specific funds, the manager s previous track record, the future earnings potential of the IME s strategy based upon current macroeconomic factors and the IME s specific advantages or disadvantages (e.g., positioning in the market, size, institutional partners, trade personnel). Expected returns can also be developed using a more sophisticated technique such as a Monte Carlo simulation. The Monte Carlo simulation accounts for the uncertainty associated with achieving the expected returns as it considers thousands of iterations of the possible returns. AUM growth assumptions can significantly impact the free cash flows and therefore require careful consideration. While historic AUM growth for specific strategies is widely tracked, it is important to note that the larger, more established fund managers and top-quartile managers with established track records typically skew such data. Therefore, it may be necessary to discount such assumptions when considering the growth rates for start-up or emerging managers. Historic AUM growth, popularity of strategy and future commitments received by the IME may all play a part in developing the AUM growth assumptions, as well. Perpetuity value is generally derived by using a constant growth model (e.g., Gordon growth model), which, as the name implies, assumes a constant AUM growth rate, generally a low or moderate rate, in the periods beyond the cash flow term of the DCF. Some seed deals contain an option whereby the IME can purchase back a seeder s equity at a specified price typically based on a multiple of the IME s earnings (buy-out option) after a predetermined number of years (e.g., five to seven years). In deals where the buy-out option is present, the terminal value may be adjusted based on the buy-out value. However, it is important to note that buy-out options can be extremely 5 Seed Investing Series

7 expensive for the IMEs to be able to execute, and therefore, unless a transaction is imminent, a discount to the contractual multiple may need to be considered. The annual free cash flows and the perpetuity value are present valued using a discount rate, which factors risk premiums such as small stock risk premiums and companyspecific risk premiums. The company-specific risk premium for seeded investments is typically very subjective and is designed to capture factors such as risk of failure in the earlier years of operations, riskiness of the strategy employed by the manager, level of competition, skill sets of key employees, diversification, capital availability and so on. Generally, the company-specific risk premium for IMEs tends to be significant, thus resulting in a discount rate that is typically high. This is especially the case in the initial years of an IME, given the high risk of failure. The fair value generated by the DCF is typically further adjusted by a discount for lack of marketability (DLOM), which captures the illiquidity and any specific restrictions associated with the equity investment. While typically, seeders use judgment to estimate the DLOM, it is good practice and recommended for US GAAP purposes to validate the DLOM with an option pricing model. The market-based multiples approach is a market approach that estimates the fair value of an IME using revenue multiples or AUM multiples derived from guideline comparable companies that are either publicly traded (e.g., the guideline public company method or GPCM) or comparable private transactions in which a private asset manager business has been sold. Revenue multiples, or the value of a company expressed as a multiple of an earnings-based measure such as earnings before interest, taxes, deprecation and amortization (EBITDA), are derived from the operating data of companies that are comparable to the IME in terms of investment strategy of the funds they manage and expected AUM growth. The earnings-based multiples selected should typically be different for incentive fee-based earnings and the management fee-based earnings. The multiples are typically adjusted for various factors such as size, scale of operations, risk concentration and diversification, and any other specific factors applicable to the IME. The same applies to AUM multiples, where the value of a comparable company is compared to its AUM to derive multiples. Typically, seed arrangements do not provide much operational or managerial control to the seeders; therefore, this approach aligns the value of the interest to that of typical minority or passive market participants such as those in the public markets. Additionally, it can also be a validation or check against the valuation derived using a DCF and can provide an understanding to the seeder of the competitive advantages and risks underlying the IME in relation to its publicly traded peers, which are typically larger and more diversified. However, this approach is typically preferred by seeders when the IME has established a track record and has sufficient external capital under management (excluding the seeder s capital). This is important because the public comparable companies typically have long-established track records, and the risk of failure is not as inherent as for start-up or new managers. Generally, at a minimum, a three-year track record is required along with a demonstrated sustainable record during a withdrawal phase in the market. When using an AUM-based multiple approach, it is necessary to have a clear understanding of the infrastructure available to the manager with respect to fundraising. As with the DCF model, values derived based on multiples may need to be capped in certain situations where a buy-out option exists. Fair value clearly plays an important role in the seeder space. It is important for seeders to consider the appropriate valuation methodology of their seeded investments, whether for financial reporting purposes or in connection with strategic transactions. In order to facilitate the valuation process, it is important for seeders to have a good set of procedures in place to gather information about the operations and projections of the seeded fund complexes in which they invest as well as relevant data pertaining to the industry in which the seeded funds operate. Seed Investing Series 6

8 About the authors: Jesse Shapiro Jesse is a partner in the Wealth & Asset Management Assurance practice and the Co-Leader of Seed Capital Services of Ernst & Young LLP. Stephan Thollot stephan.thollot@ey.com Stephan is a principal in the Transaction Advisory Services practice and the Portfolio Valuation and Advisory Leader and a member of Seed Capital Services at Ernst & Young LLP. Chintan Muchhala chintan.muchhala@ey.com Chintan is a senior manager in the Wealth & Asset Management Assurance practice and a member of Seed Capital Services of Ernst & Young LLP EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. EY is a leader in serving the global financial services marketplace Nearly 43,000 EY financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, EY is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Organization today includes more than 6,900 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America. EY professionals in our financial services practices worldwide align with key global industry groups, including EY s Global Wealth & Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients. With a global presence and industry-focused advice, EY s financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide Ernst & Young LLP. All Rights Reserved. SCORE no US BD FSO ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com