Valuing Carry

IRS regulations and the past performance of the management team are among the considerations needed to value carried interest rights

Francis Mainville | Andrew Reddington

Transferring carried interests can be appealing given the possibility of significant future appreciation in value that can be excluded from the taxpayer’s estate. Valuations of carried interests and their respective valuation reports should include the following:

  • The background of the fund, rights/economic benefits of the carried interest, and how the valuation analysis considered the Internal Revenue Service (IRS) Revenue Ruling 59-60 factors, and most importantly, what the hypothetical buyer and seller could reasonably agree to be the expected benefit from owning the carried interest under consideration.
  • Documentation sufficient to comply with the “adequate disclosure” regulations issued by the IRS, which sets the standard for values used in federal transfer tax filing purposes for purposes of computing estate and gift taxes. The statute of limitations (three years) begins only if the gift is “adequately disclosed,” in compliance with the requirements of Regulation Section 301.6501 (c)-l (f)(3)(4).
  • Factors unique to the carried interest under consideration, including the historic performance of the management team as well as the performance of similar investment strategies over a period of time sufficient to develop a reasonable range of expectations. Carried interests have no future value if the performance of the underlying investments does not exceed the agreed upon target. If the target is exceeded, the benefit increases.
  • A valuation method that captures the potential economic benefit and relies upon supportable data. Of the three approaches to business valuation (income, market, and asset-based), an income approach that considers multiple scenarios is typically relied upon to capture the asymmetric nature of the economic benefit held by the carried interest. Economic claims are often modelled as a call option or using Monte Carlo simulation techniques that capture the uncertainty of the future economic benefits as an alternative to, or in combination with, a scenario analysis.
  • In general, a supportable discount for lack of marketability (DLOM) related to carried interests can be high given the highly uncertain nature of the timing and magnitude of the expected benefits. Documentation of both the assumptions relied upon and the methods used in the development of the DLOM is a necessary and significant part of the analysis. The IRS’s DLOM Job Aid documents the methods and approaches that it considers to be relevant; and it is incumbent upon an appraiser to consider and rely on multiple methods whenever possible, and analyze liquidity attributes specific to the interest under consideration to support a reasonable DLOM.

In conclusion, carried interests can be complex and subject to a high level of scrutiny. Ultimately, the analysis and report should comply with the guidance summarized above and most importantly reasonably consider the perspective of both a hypothetical buyer and seller.


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