Navigating the Complexity of Carried Interest Valuations: An In-Depth Analysis

Introduction:

Carried interest, a fundamental concept in the world of private equity and venture capital, represents the share of gains that fund managers receive when the fund sells an investment for more than they paid for it. Carried interest valuations are often needed when carry is being gifted for estate planning or tax purposes or is transacted between parties for various purposes. In the rest of this article, we will explore the details of carried interest, exploring the definition of carry, how it is calculated, key thoughts around carried interest valuations, and more.

I. Understanding Carried Interest:

Carried interest, informally called "carry," is a performance return that general partners, or GPs, in private equity and venture capital funds earn. Usually, carry is structured as a percentage of the fund's gains. The goal of carry is to align the interests of fund managers with those of the limited partners, or LPs, who are the investors in the fund who contribute the capital and own the majority of the interest in the fund. GPs receiving any carry depends on whether the fund achieves a certain level of profitability so that fund managers are encouraged to maximize returns to the investors.

II. Calculation Methods:

The calculation of carried interest can vary, but the "2 and 20" model is one of the most common structures we see in practice. “2 and 20” means that fund managers receive a 2% management fee on the total assets under management (AUM) and a 20% carried interest on the investment gains generated by the fund (so “2 and 20” = 2% of AUM and 20% carry). We have seen in practice that the 20% carry is sometimes subject to a hurdle rate, and the goal of this is for fund managers to only receive a share of profits once a certain level of return has been achieved for investors.

a) Hurdle Rate: A minimum rate of return that the fund needs to achieve before the fund managers can receive carry. This makes sure that managers are able to achieve a certain, predetermined level of returns in order to get paid out, which should align the incentives of all parties.

b) Clawback Provision: In some cases, funds include clawback provisions, allowing LPs to reclaim carry payments if the fund's overall performance falls short over time. The goal here is to correct any overpayment of carried interest during the life of a fund.

III. Valuation Challenges and Complexities: 

Valued carry interests is a complex task and has plenty of challenges as a result. Most PE and VC private investments are not readily tradeable (illiquid), which makes determining the fair value of any carried interest an inherently more complex undertaking. Unlike publicly traded securities, the valuation of private investments may require sophisticated models and assumptions and, as we have seen in practice, this introduces a level of subjectivity that may result in disagreement from time-to-time.

IV. Regulatory Considerations:

Due to a variety of reasons, the regulatory landscape surrounding carried interest has been a subject of various levels of debate and scrutiny. Tax treatment has become a major focus and even gets highlighted in the mainstream media.  We have seen repeated discussions on whether carried interest should be taxed as capital gains or as ordinary income, and we note that this critical  distinction has implications for fund managers and their tax liabilities. This is such a contentious topic that it has even been a topic of recent legislative proposals and changes.

V. Accounting Standards and Reporting:

Financial reporting standards, including various local and international standards, provide guidelines on how carried interest should be accounted for. These standards lay out how fund managers should recognize and disclose carried interest in their financial statements, ensuring transparency and consistency.

VI. Industry Trends and Developments:

We have seen shifting trends and developments in how carry is treated and structured over the years and have noticed how various structures fall in and out of favor with investors. Many different factors influence how fund managers structure carry, and these include but are not limited to  market conditions, fundraising environment, and investor preferences .

VII. Methodology:

When valuing carried interest, the specific structure and characteristics should be considered in order to determine the most appropriate methodologies. Common methodologies include a discounted cash flow analysis, option pricing models, and monte carlo simulations or some combination of these approaches. The discounted cash flow method relies on forecasts predicting the timing and amount of future liquidity events. Future liquidity events can be difficult to predict with certainty, particularly when the companies in the fund portfolio are early stage companies and/or operating in volatile industries. The option pricing model considers the value at which carried interest starts to receive value or is “in-the-money” and relies on volatility of comparable funds or assets. The Monte Carlo simulation predicts possible outcomes of uncertain events, such as future liquidity events, based on certain parameters. Each method has strengths and weaknesses that should be considered when assessing the method’s appropriateness for a given valuation and when weighing multiple methods within an analysis.

Conclusion:

Carried interest valuations are a cornerstone of the private equity and venture capital landscape, driving the alignment of interests between fund managers and investors. The value of carried interest can vary significantly depending on the methodology and assumptions. Whether the carried interest value is used for tax purposes, as part of a transaction, or other purpose, the value can have very significant financial implications, so it is important to engage the help of a professional with extensive experience in carried interest valuation and understands the intricacies of asset. At Redwood, we have extensive knowledge of the venture capital industry and fund structures and have performed numerous valuations of carry. We would be happy to assist with any of your carried interest valuation needs.