Over the past decade, the investment management industry has given birth to thousands of dynamic firms that have achieved rapid growth and profitability. Many of these firms manage hedge funds for asset-based fees plus a percentage of portfolio gains. Global hedge fund assets have surged to more than $2.5 trillion, according to a 2007 survey by Hedge Fund Intelligence, and some entrepreneurial managers have become wealth generators within a few short years after start up.

The enormous annual compensation packages of leading hedge fund managers have been well publicized. Less visible, but perhaps more valuable, has been the growth in business equity created by investment managers of all sizes. In 2007, two large managers specializing in hedge funds, Fortress Investment Group and GLG Partners, went public at stock market valuations ranging from two to three times annual revenues. Even relatively small investment management firms, with less than $250 million in assets under management, have built valuable enterprises with persistent fee-based revenue streams and high profit margins.

How Investment Managers View Their Equity

A leading provider of accounting and auditing services to the hedge fund industry, we have developed close relationships with hundreds of management firms, providing us with a "picture window" into how successful managers view their business equity. In a nutshell, we believe many managers know they own a valuable asset, but they aren't always eager to tackle the details involved in quantifying and protecting it. This is a bit perplexing, because these people are among the most astute investment managers in the world, and management company equity often represents the majority of their net worth.

Time and again, as we review with clients their business structures and documents, we see evidence of costly "accidents waiting to happen," especially if a principal or owner should die, become disabled or leave the firm (voluntarily or involuntarily). To help protect against such accidents, we work to raise clients' consciousness on two levels: 1) conceptually, by helping managers understand barriers that keep them from taking the steps that would help maximize their equity; and 2) technically, by helping clients develop and implement concrete succession planning techniques by working closely with us and other qualified advisors.

What Are The Barriers?

Imagine a small, fast-growing management company organized as an LLC and equally owned by two members. In guiding them through succession planning, we might begin by posing this question: "If either member were to die tomorrow, who would then own the firm?"

The answer usually is found within a section of the LLC operating agreement, stating something such as this:
"Payment of Capital Accounts on Withdrawal, Retirement or Death.  In the event of the withdrawal, retirement or death of a Member, such Member shall be paid an amount equal to his portion of the Capital Account at the end of the fiscal year of the occurrence of such event..."

For several reasons, this language is insufficient and does not consider all the issues that may influence the member's ultimate stake in the company, including:

1. The member's capital accounts typically are based on the book value of the management company, not fair market value. However, successful management companies often sell for a multiple of some economic driver (i.e. annual revenues).
2. Only the financial considerations are addressed, not future operational and control issues. It leaves open the possibility that a spouse, family member or other beneficiary of a deceased member could demand the right to become active in the business, regardless of his/her business experience, knowledge or acumen.
3. The language is silent with regard to the specific terms and funding methods for buying out the deceased member, and it may produce unfavorable tax consequences for the LLC or deceased member's beneficiaries while missing estate-planning opportunities. Also, it does little to align the needs of the existing members with any new member who may join.

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