Carried Away: Valuation of Carried Interests
for Transfer Purposes
Private equity and hedge funds represent alternative investment vehicles that continue to garner increased attention among institutional investors and high net worth individuals. These funds typically maintain investment objectives focused on providing investors with an increased level of diversification, given their relatively low correlation to more traditional investments such as cash, bonds, and stocks. Alternative investing also offers the potential opportunity for increased risk-adjusted returns, which are particularly attractive in the current market environment characterized by low interest rates, uncertain equity markets, and depressed real estate values. As a result, alternative investments have developed as a viable component within a well-diversified portfolio for accredited investors. The U.S. private equity market, in particular, continued to attract additional capital over the past decade and currently maintains over $1.0 trillion in assets under management, invested in approximately 6,000 U.S. companies FN1.
Historically characterized by reduced regulation, less transparency, and low liquidity, these funds have increasingly become the target of federal regulators and taxing authorities in recent periods amid their continued growth and corresponding manager compensation. At the same time, consistent with the overall market and economic environment, these funds realized a decline in fundraising activity and deal flow during the recent recession. Although alternative investing activity is beginning to again increase, the current challenges and market uncertainty may actually present an ideal opportunity for fund managers and principals to consider and implement certain estate planning initiatives. This article first provides a general overview of the typical fund structure and the current investing environment, and then presents various estate planning options and the related valuation implications.
Private equity and hedge funds are similar in that they each provide their managers and investment principals with significant discretion to pursue a wide range of investments across multiple asset classes and portfolio companies. As compensation for their investment expertise, and in order to align their interests with those of the investors, fund managers are typically compensated through receipt of a performance fee or carried interest based on a percentage of fund profits generated above the initial invested capital and often a stipulated hurdle rate of return. The most prevalent fee structure is commonly referred to as a "2 and 20," whereby a management fee of 2% is charged on assets under management or total committed capital, and a 20% performance fee is assessed on fund profits.
As an illustrative example, the typical organizational structure and flow of funds attributable to a standard private equity fund is presented in Chart #1. The economic interest in the investment fund held by the fund managers is generally allocated into two separate components. First, the managers may invest a portion of their own capital in the fund in the form of a limited partner interest. Second, a significant portion of the managers' economic interest in the fund is attributable to the carried interest, which is independent of their respective investment contributions. As shown, after the return of the contributed capital and payment of accrued preferred returns to the limited partners, any remaining proceeds are allocated 100% to the carried interest holders until the carried interest proceeds are equal to 20% of the sum of the preferred return paid to the limited partners and the carried interest distributed, often referred to as the "catch-up" provision. Thereafter, any remaining proceeds are split 80%/20% between the limited partners and the carried interest holders.
In this example, the total cash flows realized by the limited partner interests consist of the preferred return of $587 million (4) plus the $718 million for the 80% allocation of residual profits (6). The total cash flows realized by the fund managers are then calculated as the sum of the $146 million in "catch-up" proceeds (5) plus the $180 million for the 20% allocation of residual profits (6). The total anticipated economic benefit attributable to any particular fund manager over the life of the fund may then be determined by applying his or her ownership interests in the fund and the carried interest, respectively, to the above future cash flow streams.
After reaching a historical peak in 2007, private equity investing in the U.S. declined precipitously to a bottom in 2009 following the financial crisis and economic recession, as fundraising activity was hindered by reduced investor confidence and increased liquidity constraints. More recently, given the continued uncertainty in the debt markets and concerns over the European crisis, activity in the private equity markets has remained steady, and stagnated to some extent, in terms of fundraising, deal flow, and exit activity. Chart #2 indicates that there were 321 completed private equity deals totaling $55 billion in the first quarter of 2012, which was the lowest quarter by number of deals since the third quarter of 2009 and the lowest by dollar value since the fourth quarter of 2009. As shown in Chart #3, the number of funds holding final closes remained near the low levels experienced in recent quarters, with 26 funds closed in the first quarter of 2012, raising $20 billion in total capital, compared to 28 and 33 funds raising $18 billion and $19 billion in total capital in the third and fourth quarters of 2011, respectively. Additionally, although activity has been relatively stable, the outlook for future private equity exits indicates certain signs of strength due to the large company inventory in private equity portfolios and the amount of cash available to private equity firms FN2. Notwithstanding the above, a sustained economic recovery is likely necessary in order for private equity funds to achieve results consistent with levels prior to the 2008 financial crisis.
In addition to private equity, the hedge fund industry is also in the process of recovering from recent depressed levels, as new hedge fund launches in the first quarter of 2012 increased to a level not reached since 2007. At the same time, hedge fund capital rose to a record level of $2.13 trillion, according to the latest Market Microstructure Industry Report, released by Hedge Fund Research, Inc. This trend is supported in part by declines in average management and incentive fees, increases in fund transparency and risk management capabilities, and perceived opportunities amid volatile market conditions. Further, new fund launches totaled 304 in the first quarter of 2012, narrowly eclipsing the 298 launches in the first quarter of 2011 for the highest quarterly total since the fourth quarter of 2007. However, hedge fund liquidations also increased during the first quarter of 2012, with the 232 funds closing representing the highest quarterly liquidation total since 240 funds closed in the first quarter of 2010 FN3.
Estate Planning Options
Carried interests in private equity or hedge funds present a particularly useful opportunity to transfer assets from an estate in a tax-efficient manner. This is primarily due to the fact that carried interests generally maintain a relatively low current value given the risk inherent in such instruments. This risk reflects that the realization of carried interest proceeds is generally subject to multiple factors that are speculative in nature. At the same time, such proceeds are subordinated in that they are only realized after providing a return of capital and a preferred return to the investors. Moreover, the inherent risk is particularly prevalent in newly formed funds, for which there is no meaningful historical track record of performance. The resulting low present value of the carried interest provides for the significant potential for meaningful asset appreciation that may be realized after a transfer from the estate. In this manner, the donor or seller would avoid gift and estate taxes on such appreciation. At the same time, an added benefit of transferring a carried interest, rather than a direct capital interest in the fund, avoids the need to provide cash to the transferee to fund future potential capital calls.
In consideration of the above, a number of complexities need to be considered, particularly with respect to §2701 of the Internal Revenue Code. Specifically, certain issues may arise in gifting a carried interest while retaining a capital interest in the fund, as the carried interest is considered to be a separate class of investment that is junior to the capital interest. As a result, the Service may ultimately determine the gift as the combined value of the carried interest and capital interest, resulting in a significant increase in transfer taxes. Multiple options are available to avoid such treatment, and are generally outside the scope of this article. Thus, managers and other holders of carried interests should consult with estate planning attorneys experienced in these matters. In general, however, options include 1) directly transferring an equal percentage of both the carried interest and the capital interest, often referred to as a vertical slice; 2) transferring common interests in a limited liability company or similar family investment vehicle that has been funded with both the carried interest and capital interest; and 3) transferring only the economic return on the carried interest, rather than the carried interest itself, through a carry derivative.
As noted, a number of estate planning options may be available to principals for purposes of transferring their respective economic interests in a fund's carried interest. Regardless of the selected planning technique, a valuation of the carried interest itself is generally required. In some respects, the valuation of a carried interest is similar to the valuation of other assets in that value is principally derived based on the ability to generate investment returns in the form of future cash flow. However, carried interests present challenging valuation assignments in that they represent unique assets requiring careful consideration of a number of additional factors. The most commonly utilized valuation methodologies include a Discounted Cash Flow Method and an Option Pricing Method.
Discounted Cash Flow Method
The Discounted Cash Flow ("DCF") Method 1) projects a carried interest's expected future cash flows and 2) discounts them at a rate of return commensurate with the risk involved in realizing those cash flows. First, the projection of future cash flows is premised on the fact that carried interests represent a share in the residual claim on a fund's distributions only after the return of invested capital and the payment of fees and accrued preferred returns to the limited partners. As such, the future cash flow potential of the carried interest is dependent on the fund earning a sufficient rate of return to cover fees and preferred returns. Given this unique structure involving the flow of funds, a number of factors and assumptions must be carefully considered in preparing future projections for the carried interest. Certain of the more salient considerations are outlined as follows.
- Committed Capital: Investors in private equity and hedge funds are typically limited to accredited investors that must commit to making significant investments, often in excess of $1.0 million. As a result, the pool of potential investors is limited and may be further limited in the current market environment due to liquidity constraints and reduced investor confidence. Depending on the stage of the subject fund, the valuation professional should hold extensive discussions with fund management regarding its fundraising targets, and then consider the reasonableness of such targets in the context of the current market environment.
- Capital Drawdown: The committed capital amounts are drawn upon at the discretion of the fund managers over time and put to work in various portfolio investments. The future cash flows of the fund, and thus the carried interest, are dependent upon the ability to successfully identify and exploit profitable investment opportunities. There is significant risk not only in the ability to identify suitable opportunities, complete due diligence, and close each transaction, but also in the anticipated timing for which to do so. Thus, the DCF Method requires an additional level of complexity since a fund's potential investments must be categorized into separate investment phases based on the expected time period for capital deployment. Additionally, any existing investments must also be specifically accounted for utilizing the value of the investment indicated by the fund's most recent mark-to-market value estimation, if available. Evaluation of existing investments can be of particular significance in the case that an investment has already realized a significantly positive or negative return.
- Internal Rate of Return ("IRR"): The IRR represents the annual rate of growth that an investment may be expected to generate. The IRR may be derived upon consideration of a number of sources, including 1) past performance of the fund managers, 2) market data compiled by sources such as State Street Corporation and Credit Suisse, and 3) discussions with management. The IRR impacts the expectation of the final value to be realized upon the exit of each investment and, in this regard, obviously represents a rather sensitive input to the valuation process. Additionally, consideration must be given to the source of the market data utilized in selecting an IRR (i.e., net of expenses, net of management fees, net of the carried interest, etc).
- Exit Timing: The ultimate IRR realized by a fund is to a large extent also impacted by the expected timing for an exit event. In other words, the longer the holding period incurred for a particular investment, the lower the IRR realized by the fund, holding the exit value constant. The estimation of an appropriate holding period is thus an important consideration and involves an analysis of 1) the types of investments to be held by the fund, 2) various empirical studies of historical market data, and 3) the current investing environment. In particular, although private equity exits have increased since the first quarter of 2009, exit activity remains below historical levels due largely to a reduction in the availability of transaction financing. When compared against the significant amounts of capital raised in 2004 through 2007 (i.e., funds that would ordinarily begin harvesting investments now), it becomes apparent that exit activity must increase significantly in order to avoid continued extended holding periods.
- Capital Allocation: Each of these factors is utilized in estimating the amounts and timing of the estimated future cash flows of the fund. These future cash flows must then be allocated among the limited partners and the carried interest holders based on the specific terms and "waterfall" provisions of the particular fund. For this purpose, the valuation professional is required to comprehensively review and understand the fund's allocation structure, as typically defined in its partnership agreement, offering memorandum, prospectus, and other fund documents.
The projected cash flows to the carried interest in each year are then discounted to their present value equivalent at an appropriate rate of return. The selected carried interest rate of return is one of the more important, and difficult, inputs to the valuation analysis. First, the rate of return must incorporate the risk and volatility of the underlying investments held by the fund. However, since the hurdle or preferred returns to the limited partners must be paid before any net proceeds are paid to the carried interest holders, the projected cash flows attributable to the carried interest are riskier than the projected cash flows associated solely with the invested capital. As a result, the rate of return applicable to the carried interest is higher than the gross portfolio rate of return of the underlying assets because of its residual claim on the returns produced by these assets. A number of factors, outlined below, should be considered in order to fully support the incremental premium that an investor would require to invest in the carried interest.
- Qualitative Factors: Ultimately, a carried interest represents a subordinated interest in the returns generated by a fund. Thus, an investor in a carried interest would require a premium to incorporate the fact that it maintains only a residual claim on a fund's returns. The extent of the premium is subject to the facts and circumstances of each situation and requires extensive valuation experience. Various qualitative factors that should be considered focus on those that would reduce the ability to realize significant carried interest proceeds, including the level of the hurdle or preferred return, the strategy of the fund, the current market environment, etc.
- Legislative Actions: Proposals by politicians to balance the federal budget deficit, raise tax revenues, and support fiscal stimulus continue to consider an increase in the taxes on carried interests. The proposed changes include an increase in the federal tax from a current rate of 15.0% (i.e., carried interests are currently taxed at the long-term capital gains tax rate) to the marginal ordinary income tax rate, which can be as high as 35.0%. This change amounts to a substantial increase in the tax liabilities for carried interest holders. As such, this change would significantly decrease the value of carried interests and represents an additional risk factor that should be considered in deriving the appropriate rate of return.
- Quantitative Analysis: The incremental premium may also be algebraically calculated based on the premise that the internal rate of return for the investment portfolio as a whole should reflect a weighted average of the separate rates of return required by the individual investors, which would include specifically 1) the limited partners as providers of the investment capital and 2) the investment professionals as the carried interest holders. In other words, given the overall IRR and weighting to the limited partners (based on market data) and the specific preferred return of a fund, it is possible to solve for the rate of return attributable to the carried interest holders.
Finally, the selected carried interest rate of return is applied to the annual projected cash flows attributable to the carried interest to derive an indication of the present value of the carried interest.
Option Pricing Method
An alternative to the DCF Method is to compare the features of a carried interest to the features of a call option. A carried interest position is similar to a call option in that it represents the right to the value of an investment above a predetermined level (i.e., the strike price). In particular, a carried interest's "strike price" is the committed capital plus the hurdle or preferred return. Based on the similarities of the features of a carried interest compared to a call option, the Black-Scholes Option Pricing Model ("Black-Scholes Model") may be used as a second indication of the present value of a carried interest.
The Black-Scholes Model is the predominant method in estimating option prices and represents an arbitrage-pricing model that was developed using the premise that if two assets have identical payoffs, they must have identical prices to prevent arbitrage (i.e., riskless profit). The Black-Scholes Model calculates the price of a traditional call option by analyzing the volatility and opportunity cost of investing in the underlying asset. The Black-Scholes Model's formula and individual components are as follows:
C = SN(d1)-Xe-rTN(d2)
- Asset Value (S): Similar to the DCF Method, the fund's potential investments are categorized into investment phases. In this case, the asset price is equal to the projected capital to be deployed for each anticipated investment, reflecting the initial value of capital available to both the limited partners and the carried interest.
- Strike Price (X): Based on the terms of the fund agreement, each investment phase may require the valuation of multiple call options, with varying strike prices according to the asset values at which there is a change in the manner in which proceeds are allocated among the limited partner investors and the carried interest holders. In other words, the limited partners first receive 100% of proceeds until the return of invested capital and receipt of the preferred return (Strike Price #1). Thereafter, funds typically provide for a catch-up provision allowing for a disproportionate allocation of proceeds to the carried interest holders until the point at which their cumulative distributions equal a standard allocation (typically 20%) of total amounts distributed (Strike Price #2) FN4. Beyond that point, all remaining proceeds are typically allocated 20%/80% (or other stipulated allocation) to the carried interest holders and limited partner investors, respectively.
- Time to Maturity (T): Estimated investment holding period for each investment phase.
- Risk-Free Rate of Return (r): Return for U.S. Treasury securities at a point on the yield curve corresponding to the estimated holding period for each investment phase.
- Volatility (N(d1) and N(d2)): One of the more sensitive and difficult inputs, volatility must be derived based on consideration of market data, particularly those indexes with similar investment strategies and characteristics as the underlying portfolio investments of a particular fund.
The Black-Scholes Model is applied to each separate investment phase over the life of the fund, resulting in multiple option value calculations for each investment phase (i.e., one for each strike price). The allocations of the resulting call option values attributable specifically to the carried interest are then calculated for each investment phase. An example of this calculation is presented in Chart #4 which for illustrative purposes involves the calculation of two option values for each investment phase. First, the carried interest receives a certain catch-up percentage (in this case 100%) of the asset value above Strike Price #1 until the asset value exceeds Strike Price #2. At this point, the allocation of proceeds changes to a stipulated sharing ratio between the carried interest holders and the limited partner investors (typically 20%/80%). As a result, the carried interest receives 1) 100% of the incremental option value between the first and second call options, and 2) 20% of the value attributable to the second call option. Finally, due to the fact that these option values typically represent future values (i.e., call option values as of future investment dates), the present values of these amounts for each investment phase are calculated based on a rate of return that incorporates the risk of holding an investment in the carried interest proceeds (as in the DCF Method).
Monte Carlo Method
The previously mentioned valuation methodologies incorporate a number of inputs that require a certain degree of uncertainty, particularly given that the valuation is often performed at the initiation of a fund before a historical record of investment performance has been established. In order to appropriately address such uncertainty, a Monte Carlo analysis should be considered to supplement the more traditional DCF Method and Black-Scholes Model, which are more deterministic in nature. In contrast, Monte Carlo methods are probabilistic in nature and involve statistical sampling techniques that simulate the various sources of uncertainty and calculate an average or expected value over a range of thousands of resultant outcomes.
The application of a Monte Carlo analysis involves first developing an income-based analytical model similar to the DCF Method and Black-Scholes Model that incorporates many of the same drivers of value, such as fund size, expected return, holding period, volatility, etc. The key assumptions revolve around the assumed distributions and distribution parameters for a particular fund.
A Monte Carlo simulation analysis can then be performed on the model by running multiple scenarios incorporating a range of values for the key value drivers. The Monte Carlo simulation ultimately returns an expected value based on the outcomes for the numerous scenarios and, in this regard, provides a significantly comprehensive and robust analysis. Thus, the valuation professional should have experience with statistical modeling in general and Monte Carlo analyses in particular.
Hedge Fund Carried Interests
Consideration of a Monte Carlo methodology is particularly useful and effective with respect to the valuation of hedge fund carried interests. To this point, our discussions have primarily considered the valuation of a typical private equity carried interest. The characteristics of a hedge fund carried interest, however, may differ quite substantially from those of a private equity carried interest, and thus render consideration of a statistical analysis such as a Monte Carlo method particularly meaningful.
Hedge fund carried interests are calculated and distributed at the end of each calendar year or reporting period and typically range from 15% to 20% of any new appreciation in the net asset value of any given capital contribution. New appreciation, if any, equals the amount by which the net asset value of a capital contribution exceeds the high water mark ("HWM"), which represents the greater of 1) the highest net asset value of such capital contribution as of the end of any previous reporting period, or 2) the amount of the initial capital contribution.
Based on these features, the aggregate value of a hedge fund carried interest can be characterized as a call option written on the net asset value of the fund with a strike price equivalent to the fund's aggregate HWM. However, depending on the returns achieved by the fund, the HWM is reset as of the end of each reporting period, thereby introducing an additional variable in the valuation process. In other words, the option value of the carried interest changes as the strike price continually adjusts. Given these relevant features, the value of a hedge fund carried interest can be characterized in terms of a path-dependent option pricing framework.
The valuation of a hedge fund carried interest requires the following key components.
- Fund Size: Projected fund size must consider multiple components and inputs, including initial capital raised, expected return, volatility of returns, management fees and fund expenses, and capital contributions and withdrawals. The projection and summation of these factors generate increases and decreases in fund size from one period to the next.
- Fund Life Cycle: Several empirical studies have attempted to quantify the various factors that influence the life cycles of hedge funds. The valuation professional must appropriately consider the specific characteristics of the fund in addition to industry trends in order to appropriately capture the anticipated life of the fund.
- Calculation of Carried Interest Proceeds: The HWM must be calculated and reset appropriately in each period in order to calculate the present value of the carried interest proceeds for each reporting period of the fund's life.
Private equity and hedge funds represent a significant source of private wealth for their principals and managers in the form of potential carried interest or incentive compensation. However, such incentive compensation will often not be received until an uncertain future date and is further dependent upon a number of factors. Thus, significant risk exists regarding whether such amounts will ever be fully realized, particularly at the time of the initiation of a fund before it is fully invested.
This risk reduces the overall value of the incentive compensation, a factor that is further exacerbated in the current market environment. In particular, funds are realizing more difficult fundraising efforts, extended holding periods, and lower IRRs, all of which reduce the value of potential incentive compensation. At the same time, there is additional risk in the form of increased regulation and scrutiny imposed by the recent Dodd-Frank legislation, as well as ongoing political pressures to increase the tax rates attributable to this form of income. As a result, the current market environment presents significant opportunities to structure estate plans around the carried interests and performance fees at attractive valuations.
Marcus A. Ewald, CFA is a Director in the Valuation & Financial Opinions Group at Stout Risius Ross (SRR). He specializes in valuations prepared for transaction advisory purposes, estate and gift taxation, succession planning, and other tax, corporate, and litigation related matters. He serves as leader of SRR's Consumer Staples practice and also has extensive valuation experience across numerous industry segments, including the valuation of limited partner interests and carried interests in private equity and hedge funds, as well as their underlying portfolio companies. Mr. Ewald can be reached at +1.312.752.3346 or firstname.lastname@example.org.
1 The PitchBook Private Equity Decade Reports, Vol. 1: Fundraising 2001-2010, PitchBook Data, Inc., 2011, 3.
2 The Private Equity 2Q 2012 Breakdown, PitchBook Data, Inc.
3 Hedge Fund Launches Accelerate as Support for Bank Regulation Builds, Hedge Fund Research, Inc., 15 June 2012.
4 Based on the terms of each individual fund agreement, it may be necessary to consider additional strike prices in the event that the catch-up percentages for the carried interest holders differ at varying asset values.