The 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.
So, what 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. In exchange for managing this pool of assets, the manager receives two fees: a management fee, usually a percentage of assets under management (“AUM”), and a performance fee known as carry or a carried interest. 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 amount of this fee varies, but is typically 20% of profit or appreciation.
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. Carried interest participates in the profit or appreciation in a fund’s AUM after an agreed-upon investor requirement is met. 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 claw back provision gives investors a mechanism to "claw back" paid carry during the fund’s life to adjust total carry paid to the originally agreed upon percentage. 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.
Discounted Cash Flow
Understanding the nuances of each management agreement between the fund manager and investors - usually the limited partners in a Limited Partnership - is critical to employing appropriate valuation methods. One approach to valuing carry is the discounted cash flow (“DCF”) method under the Income Approach, one of three valuation methodologies used by appraisers. 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. A DCF method must factor in all the obstacles – such as a high water mark, claw back, hurdles rate, and tiered participation – to achieving the “leftover” profits after all investor requirements are satisfied. 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.
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. Finally, the discount rate must reflect the residual nature of the carried interest, meaning the discount rate should consider the risk of receiving the carry cash flows only after all investors’ requirements are met.
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. Similarly a carried interest will receive carry once the investors’ hurdles, discussed above, are met.
Black Scholes Option Pricing Model
Another method used to value carried interests is to use an option pricing model, the most common being the Black Scholes Option Pricing Model (“BSOPM”). 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 rate), the option's strike price, and the time to the option's expiry.
Similar factors in the application of DCF model are considered when applying BSOPM. 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.
Getting it Right
Measuring the value of carried interests is an exhaustive exercise that requires an extensive understanding of the subject fund’s investment strategy, capital draw down expectations, legal memorandums outlining investor requirements, and industry research. There are many ways to incorrectly value carried interests. Misinterpreting the fund offering memorandums and the fund manager’s legal obligations to investors can lead to widely disparate valuation conclusions. 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.
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