Carried Interest Valuations
July 29, 2016
What Business Leaders/Fund Managers Need to Know About Carried Interest Valuations
What Are Carried Interest Valuations?
Carried interest is a tool used to incentivize general partners (fund managers) to increase the performance of a fund. Carried Interest gives the general partner the right to a higher percentage of the profits than a limited partner. While a general partner may only contribute a small portion of the fund’s total capital, carried interest grants the general partner a greater portion of the profits in consideration of managing the fund.
The most common carried interest is known as the “2 and 20”, where there is a 2% management fee and a 20% claim on the fund’s profit. In some cases, the carried interest is only of value to the general partners if they can earn a greater return than a predetermined rate of return to its investor, also known as the hurdle rate. Typically, the right to carried interest will provide general partners with 20-25% of the fund’s profit. A good way to think about carried interest in terms of valuation is the claim on the future profits of a fund, and because the future cash flows of a fund are uncertain and risk is involved there may be a need for a valuation of this asset in certain circumstances.
When Are Carried Interest Valuations Needed?
A carried interest valuation is performed for transfer tax purposes (tax imposed on the transfer of title from one person/entity to another). The valuation should consider the value of the investments currently in the fund, the future returns of the fund, the legal structure of the fund, the discount for lack of marketability (DLOM), etc.
With the potential for high growth and low current value (due to risks involved with a funds returns), carried interests are a probable candidate for use within an estate plan. Due to tax laws governing gift and estate plans, valuations must be performed to execute the taxation (link to gift & estate valuation paper). In a like manner, whenever carried interest is transferred from one entity to another a valuation is required for transfer tax purposes.
There are also times when a company will need to value the carried interest offered to general partners. Often times, these events occur before the fund has any profits at all, especially in the case of a newly formed private equity firm. In these situations and others, a third party valuation firm performing the valuation can be determine the value of carried interest held by the general partners.
Professional Third Party Valuations
Assessing the risk involved with a fund and making appropriate projections of future can be difficult and complex requiring expert knowledge and understanding. By having the valuation performed by a professional firm, carried interest holders can feel confident that the value of their carried interest is accurate, which in turn can provide reassurance that they are paying appropriate taxes and avoiding stiff penalties from the IRS.
However, it shouldn’t be assumed that any valuation firm will be a good candidate to value carried interest. Individuals seeking valuations of their carried interest should seek firms with experience valuing carried interests. These firms understand the risks and factors that contribute to the value of carried interest. This should be a critical differentiator in selecting which valuation firm to perform the valuation.
Each carried interest has different provisions involved depending on the fund and how each firm wants to incentivize the general partner. Therefore, the fund/individual should ensure they provide legal documents, fund prospectus, and any other documents that have implication on the carried interest or the funds’ performance. With all of the appropriate information given, the valuation firm will conclude on an appropriate value for a given carried interest.
Valuation Research Carried Interest Article: http://www.valuationresearch.com/knowledge-base/alert/valuing-carried-interests