Related Services. Th e subject of carry and carried interest has been receiving media attention for several years, particularly in connection with tax reform discussions. Most recently, savvy owners of carried interest have been transferring the fair market value of this highly appreciable asset out of their estates, taking advantage of valuable estate and gift tax planning opportunities.
Sowhat is this carry? And how is it valued? Carry or a carried interest is a performance fee earned by an alternative investment fund manager, be it a hedge fund or private equity fund, entrusted with managing a pool of investment assets on behalf of a group of investors. This carried interest is tied to the profits of the fund and is earned on the appreciation of assets of the underlying fund investments, allowing fund managers who generate profits for investors to share in those gains.
The valuation of a carried interest involves, among other things, understanding fund strategy, predicting returns, and measuring the threshold at which the holder participates in the carry profits. These requirements come in many forms but commonly are in one or a combination of a high water mark, a claw back, a hurdle rate, and a tiered participation. A high water mark is the highest peak a fund has reached and a high water provision requires the manager not receive any carry until the fund recovers to this mark.
A hurdle rate is the rate of return that the fund manager must generate before collecting carry fees. Finally, tiered participation refers to differing distribution waterfalls by which capital is distributed to a fund's investors, and carried interests based on different levels of return and appreciation of AUM.
In using the DCF method, future projections of expected carry profits are discounted using a risk adjusted discount rate that encapsulates the risk of attaining the projected carry profit. Application of the DCF method requires extensive conversations with fund managers regarding the above factors, but also the timing of investment exits, capital draw down, and expected return.What is \
The expected return should be based on discussions with management, a review of past performance of the fund manager, and market comparable returns of funds with similar investment strategies. Once the carry cash flow projections are formalized, a discount rate needs to be developed. This discount rate must accurately reflect the risk and volatility of the underlying investments on which the carry will be earned. This residual concept in many ways is synonymous to the residual value of a common stock option holder.
A holder of a call option will realize value if and when the market value of the common stock exceeds the option strike price. The math of the BSOPM is not within the scope of this article, but essentially the model incorporates a constant price variation volatility of the stock, the time value of money risk free ratethe option's strike price, and the time to the option's expiry. The market value of the underlying investments is an input and requires an understanding of the capital call expectation.
The strike price of the carry will be based on the fund management agreement and will account for all thresholds over which carry can be earned. The holding period will be based on discussions with the fund manager and will reflect the investment holding periods.
The risk free rate will be based on commensurate returns on treasury securities with similar holding periods. Finally the volatility applied in the model should be based on comparable funds with similar investment strategies. There are many ways to incorrectly value carried interests. In preparing a DCF model, especially for hedge funds, ignoring reinvestment and redemptions can lead to huge swings in value.
Finally, using weak comparables with different investment strategies can lead to volatility measurements that under or overstate the value of future potential carry.Two of the most common types of alternative assets are private equity funds and hedge funds. While their structures are similar, investment terms and the criteria for compensating general partners vary. Acting as the general partner or investment manager of such funds can represent many millions of dollars in carried interest and incentive fee compensation.
As a result, it is important to hire the right expert with experience in valuing these interests who can support efficient planning and case resolution. Most importantly, obtaining a defensible valuation will mitigate risk and help to avoid common mistakes that can lead to challenges down the road. Qualified investors are attracted to alternative asset investments due to the potential for higher returns, often with hedged risks. These investors typically include pension and endowment funds, institutional investors, as well as individual accredited investors.
According to Yahoo Finance there are more than 10, hedge funds and by some estimates the number could be as high as 15, The space has become very crowded. With such a crowded space, many hedge funds are unable to deliver the performance they advertise. Although hedge funds are self-reporting and do not report to the SEC, according to the data firm, Hedge Fund Research, more hedge funds closed down in than were opened. The PE fund space is also very crowded, with many funds having a difficult time deploying capital and finding quality acquisition targets.
Larger private equity firms have also experienced challenges in accessing debt financing to close deals in the past year. So what is the attraction? Additionally, for most private equity fund managers, the current federal tax code allows the treatment of such compensation as long-term capital gains which are taxed at a lower rate than ordinary income tax rates reported by most taxpayers. While the organizational structures tend to be similar, there are differences between how general partners investment managers are compensated in private equity funds and hedge funds.
These differences can be critical when determining the value of their interests. Though the management compensation structures differ between hedge funds and PE funds, they are similar in one respect.
Fees can vary from fund to fund, with some charging less and others charging more. Carried interests are generally calculated and distributed at the end of each calendar year or reporting period. As shown, the subjects of valuation are usually interests in the General Partner entity, Management Company, and sometimes, the Master Fund. P rivate equity is a generic term identifying a family of alternative investing methods.
PE firms generally invest in the equity of privately held companies or real estate, as well as vehicles that hold debt investments. These funds are often classified into categories according to the investment strategy of the fund, such as leveraged buyout funds, growth equity funds, venture capital funds, real estate investment funds, and mezzanine or distressed funds.
Private equity general partners who function as investment managers are responsible for making all decisions surrounding the activities of the fund, including acquisitions, and capital calls and divestitures.
A Primer on the Valuation of Hedge Fund and Private Equity Fund Management Interests
As discussed previously, the management fee component usually falls in the range of 1. Typical expenses incurred by the management company include employee compensation and bonuses, rent, research and data costs, travel, insurance, and professional fees.
The typical fund structure is complex with the management company usually formed as a separate entity. In some cases, the general partner entity will own the management company. In others, the management company and general partner entity will be separate entities owned by the same individuals. In addition to a return of capital, many PE funds also provide for a preferred return or hurdle rate to the LP investors before any carried interest will be earned by the general partner.
As a result of the distribution waterfall and the long investment horizon, the general partner usually only receives its carried interest upon a successful exit from an investment, which may take years. This fee can vary from fund to fund.Valuing carried interests also known as performance allocations for transfer tax purposes poses several unique challenges as compared to more traditional business valuation engagements.
Carried interests will have various definitions for specific funds, but in general are defined as the right of the general partner to receive a percentage of profits above a limited partner return threshold.
A common example is a 20 percent carried interest right to the profits above the return of limited partner capital. The carried interest shares in the upside of value in excess of the threshold, but does not suffer from any of the downside below the threshold.
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. A typical information request will include legal documents such as the limited partner and general partner agreements, audited financial statements, fund information memorandums, past performance of the funds and expectations regarding committed capital and capital draw downs.
This information is critical to understanding the nature of the carried interest, the transfer restrictions, the expected timing of distributions and the expected capital for investments. Each carried interest has unique characteristics and the proper documentation will assist in the replication of the analysis by a third party such as the IRS.
A report supported by documentation and meaningful discussions with the client will provide a more defendable valuation conclusion. Of the three approaches to business valuation income, market and assetthe income approach should be relied upon in the majority of carried interest valuations. The unique nature of each carried interest will usually make it difficult to find directly comparable market data to apply a pure market multiple approach, although market data is necessary to apply the income approach.
The asset approach can be taken into consideration, especially if investments are marked to fair value in audited financial statements; but the asset approach will typically not appreciate the asymmetric nature of the carried interest.
Methods within the income approach often relied upon are a discounted cash flow DCF analysis, option pricing methods and a Monte Carlo simulation.
A DCF analysis forecasts the expected cash flow to the carried interest and discounts these expected cash flows at a risk-adjusted discount rate. A multiple scenario DCF analysis should be considered to capture the asymmetric nature of the carried interest. An option pricing method such as the Black-Scholes option pricing model is often a relevant method to consider. Advantages of an option pricing method include limited inputs that are easy to audit and the consideration of a wide range of possible scenarios in a closed form model.
For example, a carried interest with a claim on 20 percent of the profits gains in excess of investors? A Monte Carlo simulation method relies upon the simulation of thousands of iterations of a wide range of future scenarios. A Monte Carlo simulation can be useful for very complex situations that are difficult to model with a DCF or option pricing method, but appraisers should use caution in using this method if a more simple method will reasonably capture the carried interest value.
A forward-looking model requires assumptions regarding the expected range of the future benefit to the carried interest, the timing of the benefit and the appropriate discount rate to calculate the present value of the expected benefit. The forecast of the expected carried interest benefit begins with a forecast of expected liquidation values of the investments held by a fund.
The valuation should consider capital that has already been drawn down as well as expected future capital drawdowns. Although future capital drawdowns are uncertain, the carried interest does benefit from these drawdowns and they would likely be considered by the hypothetical buyer and seller, with an appropriate risk factor added for the additional uncertainty relative to capital already drawn down. Considerations in the process of developing expected returns on investments will include past returns on those investments, general industry returns for similar investments and the expected volatility of the investments.
As stated earlier, the asymmetric nature of carried interests requires the consideration of a range of scenarios. Therefore, both the average expected investment return and dispersion from the average are important variables to consider.
Private equity represents one of the major asset classes within alternative investments, which has exhibited tremendous growth over the past few decades.
Private equity funds, typically organized as limited partnerships, are professionally managed pools of capital that make leveraged corporate equity investments. Many pension funds, endowments, and other institutional investors act as limited partners and provide the majority of the investment capital in these private equity funds.
Private equity fund manager compensation, which consists of a combination of annual fees and a carried interest in the fund, has attracted increased scrutiny in recent years. Regulators have requested that public pension funds that invest heavily in private equity funds report all the fees they have paid, but many large pension funds have not performed this calculation and thus may have unknowingly paid excessive fees.
The models will enable limited partners to value the carried interest and quantify expected total manager compensation, which will take on increased importance during boom periods. The models will enable limited partners to negotiate a fund manager compensation structure that exhibits a proper balance between fixed compensation and variable compensation.
During periods of popularity for private equity funds, total private equity fund manager compensation increases because of higher management fees and a shift in compensation from carried interest variable compensation to fees fixed compensation.Marcum Coronavirus Resource Center Details. By Vladimir V. KorobovPartner, Valuation and Litigation Support. As a type of incentive compensation, carried interest and similar profit-sharing arrangements 1 have been around for a long time.
The notion of carried interest dates back to medieval times and relates to the share of profits that ship captains received on the cargo they carried. Carried interest has been a staple of the private equity and venture capital industries in the United States for many years. In a typical private equity or venture capital fund, outside investors, i.
Following is an example of a typical formula for an allocation of proceeds from the sale of a portfolio investment in private equity and venture capital funds:. Second Allocation: Proceeds initially allocated to the limited partners are then reallocated between the limited partners and a general partner as follows:.
It is not a surprise then that this asset has been a popular choice in gift and estate planning for private equity and venture capital professionals in the United States. Internal Revenue Code; however, income tax considerations are not the only purpose for valuing carried interests. Questions concerning the value of carried interests frequently arise in litigation for example, in matrimonial matters and employment disputestransactions, and financial reporting.
We often get this same question from our private equity and venture capital clients. And the answer, in most cases, is generally no 6 for at least three reasons. Second, unless there is a reasonable expectation that the investments could be sold off at the values set by the general partner over a short period of time, the hypothetical liquidation scenario does not reflect the time value of money. Thus, the hypothetical liquidation scenario does not consider a potential for future appreciation of the value of the investments, i.
So, if the hypothetical liquidation scenario is not the right answer to the question of value of a carried interest in most cases, then what is? The right answer to the above question is the present value of the expected cash flow, or the carried interest distributions expected to be received over the life of the fund. The present value can be determined utilizing either an option-pricing framework, or a discounted cash flow methodology.
In this article, we will illustrate a valuation analysis using the discounted cash flow methodology. Let us consider the following scenario. The general partner of the fund has made a capital commitment of 1. The fund has a term of 10 years 9which is divided into the investment period the first five years and the investment exit period the last five years.
Based on experience with earlier funds and consideration of the expected industry trends and investment opportunities that these trends could present over the next 5 to 10 years, the general partner expects an average holding period for investments to be 5 years, and believes that the fund could realize value of 2 times invested capital.
The general partner estimates the following capital drawdown schedule during the investment period: We can then allocate the projected proceeds between the general partner and limited partners using the typical waterfall presented earlier:. Now that we have identified the future carried interest distributions — specifically, the distributions to the general partner in Steps 3 and 4 — we can determine the value of the carried interest as the present value of the projected carried interest distributions.If you have any problems with your access or would like to request an individual access account please contact our customer service team.
This was in stark contrast to the predictions for Q2 in which every underwriter stated there would be no change in rates for this type of cover.
Carried Interest: What it Represents and How to Value It and Why
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Valuing a Private Equity Carried Interest as a Call Option on Fund Performance (Digest Summary)
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Total retail sales for the holiday season of November and December will grow by 3. That sounds like good news, but it's actually less than the 4. It's not that people are shopping less or not buying as much. Instead, sales totals are being driven down by increased discounting. This holiday season growth rate is also below the expected 3.
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The Price of Profits: How Carried Interest is Valued
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