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.
It is important to note that fair market value (FMV) is the applicable standard of value based on the definition prescribed under Internal Revenue Service (IRS) Revenue Ruling 59-60 (59-60) and Treasury Reg. 25.2512-1, as follows:
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.
The valuation report must sufficiently document the background of the fund, rights/economic benefit of the carried interest, how the valuation analysis considered the 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.
The appraisal of carried interests typically involves the following steps:
- Information gathering. Includes legal documents that define the economic rights and obligations of the carried interest that enable the appraiser to develop a reasonable and supportable expectation of the benefit to be received by the owner.
- Selection of valuation methodology. Captures the potential carried interest benefit and relies upon supportable data.
- Development of valuation assumptions. Considers the distribution of future underlying investment values and the holding period of investments. The expected future benefits are then discounted back to the present at a discount rate appropriate for the valuation model applied and the risk characteristics of the carried interest.
- Development of a discount for lack of marketability. In general, the supportable discount for lack of marketability related to carried interests can be high, although the proper support for discounts can be challenging.
- Disclosure and documentation. Documentation in a valuation report that sufficiently reflects the disclosure requirements of the IRS and clearly presents the assumptions relied upon to arrive at the concluded fair market value. Proper documentation will allow a third party such as the IRS or relevant state department of revenue to replicate the report and understand the thought process behind the numbers.
INFORMATION GATHERING AND DOCUMENTATION
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.
Valuation Method Selection
Appraisers should select a method that properly captures the features providing value to æthe carried interest while appreciating the information available to apply each method in a reasonable manner.
Of the three approaches to business valuation (income, market and asset), the 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? contributed capital) can be modeled as 20 percent of the value of a call option with an exercise price equal to the contributed capital. 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. For example, a fund may expect the average investment to generate a return of two times (2X) the purchase price. However, the value of the carried interest may not be correctly estimated based on this average expectation, as investments returning greater than 2X may have a disproportionate impact on the value of the carried interest relative to investments providing returns less than 2X. A reasonable analysis, therefore, needs to consider the realization of scenarios above and below the expected average.
The determination of the expected time to receive the carried interest benefit is based upon a review of the legal documents, discussions with management and an understanding of the fund investments. The legal documents will usually provide some guidance regarding when the carried interest can expect to receive distributions and the legal life of the fund. Discussions with management and an understanding of fund investments (i.e., stage in the fund life cycle) can often provide valuable insights into expected timing that are not clear in the legal documents.
The nature of carried interests can justify relatively high discount rates. The selection of a carried interest discount rate begins with an understanding of the expected return of underlying fund investments from available market information that is consistent with the information relied upon to develop expected investment returns. For example, the benchmark for a fund investing in large capitalization stocks may be expected returns for the S&P 500 index, while the benchmark for a venture capital fund will be higher due to the higher risk and higher historical returns of venture capital investments.
An appraiser must ultimately determine the risk of the carried interest relative to the underlying fund investments based upon a variety of quantitative and qualitative factors. The uncertainty/volatility of returns and the required rate of return are closely related, with investors demanding high rates of return for investments with greater uncertainty of future returns. The asymmetric claims of carried interests can significantly increase the uncertainty of future expected returns, with the value of the carried interest being highly sensitive to changes in fund investment returns. Therefore, there is often a reasonable qualitative argument to rely upon a high discount rate for the carried interest; while quantitative models that compare the expected volatility of the carried interest to the underlying fund investments can assist in substantiating a higher discount rate.
Discount for Lack of Marketability
For tax valuations, a Discounted for Lack of Marketability (DLOM) should be considered. Specific factors that will have a large influence on the DLOM of a carried interest include the expected timing of distributions, expected volatility of the carried interest and transfer restrictions. The timing of expected distributions can vary widely between different types of investments and different funds. For example, hedge funds investing in liquid public investments can be expected to distribute the carried interest on an annual basis while it may take venture capital funds several years to realize a cash benefit from investments. Additionally, distribution policies vary widely between funds, with some funds distributing shortly after each investment liquidation while other funds have clawbacks that increase the time to distribution.
The valuation of carried interests may be needed at various stages of the Fund’s life. Following are two recent examples of carried interests valued at the beginning of the Fund’s life as well as the later stage.
VRC valued the carried interests of a fund that had not yet been activated. A prospectus had been written, governance documents drafted, investors lined up and funds committed, but aside from having an investment strategy and team in place, no investment funds had been collected.
The primary method used in this situation was the income approach in the form of the DCF method. The projected cash flows were based on discussions with management concerning:
- timing and magnitude of investments during an estimated investment period
- the average duration of investment to exit
- expected gross return on investment (ROI) multiple of exited investments
- projected general partner management fees
- projected organizational and partnership expenses
- cumulative preferred returns, and
- expected distributions to all partners during the term of the fund based on the preferences of each partner type
We presented three scenarios by varying the deal-by-deal gross ROI multiple. These multiples were estimated based on the performance of previous funds by the same sponsor as well as industry performance of funds with a similar strategy. A higher discount rate was used to determine the present value of the expected cash flows due to the uncertainty concerning each of the inputs mentioned above. As a sanity-check, the Black-Scholes model was also applied for the DCF method.
For the valuation of the carried interests in a later stage fund, we also utilized the DCF method as the strongest value indication. In this situation, the private equity firm provided us with a forecast of expected cash flows resulting from the expected magnitude and timing of its remaining investments.
There is typically a stronger set of data to rely upon in a later stage fund because of potential relevant performance involving realized investments as well as recent marks on unrealized investments and greater visibility into expected exit dates of unrealized investments. As a result, a relatively lower discount rate was used in this situation.
The transfer of carried interests can be appealing as a result of low supportable current values relative to potential future appreciation. A defensible report will include adequate documentation of the information and factors considered, an appreciation of the unique nature of each carried interest, selection of a valuation methodology consistent with the nature of the carried interest and supportable assumptions for key factors such as expected future returns, discount rates and discounts for lack of marketability. For more information regarding carried interests valuations, contact a VRC professional.