Common methods for carried interest valuation

Often, funds will offer a portion of their profits to their general partners and fund managers as carried interest. The idea is to encourage fund managers to perform better and align their interests with investor interests. Carried interest can form a major chunk of a fund manager’s income, and as we all know, where there is income, there is income tax.

So, for fund managers, accurately valuing the carried interest is key to managing their tax liability. To help you do just that, we will discuss the meaning of carried interest, carried interest valuation methods, and some strategies for minimizing taxes on carried interest.

Carried Interest and Valuation Methods

Private equity (PE) funds are known to offer carried interest to their general partners and fund managers. Typically, carried interest is 20% of the profits earned by the fund. If the investors have already received a certain level of returns, the carried interest might be even higher. Sometimes, carried interest may be distributed only after a certain level of return is ensured for the investors. PE funds are also known to offer time-based incentives.

How Is Carried Interest Calculated?

The carried interest amount depends on fund agreements, fund performance, projected performance, and discounting methods.

Since carry interest is calculated as a percentage of profits, it is plain to see that changes in fund performance affect the carry interest. Also, in the early life of a fund, carry interest must be calculated based on the projected performance since most PE funds will not have clear visibility of their expected gains at this point.

Fund agreements can have terms like hurdles, time-based incentives, and incentives for outperforming goals. Typically, fund managers must ensure a certain rate of return for the investors before they can be issued carried interests. This required rate of return is called the carry hurdle.

Additionally, PE firms may offer higher carried interest in the early days than in the final years to offset the uncertainty in returns. Some methods that can be used to discount carried interest, or essentially value carried interest, are the option pricing method, discounted cash flows (DCF) method, and current liquidation method.

Valuation Methods For Carried Interest with Examples

Here we added important valuation methods for carried interest valuation.

Options Pricing Method

You can interpret carried interest as a call option that gives fund managers the right to receive a certain percentage of profits if the fund’s performance exceeds the carry hurdle. A popular method to derive the value of options is the Black-Scholes method whose inputs are the current price, strike price, time to maturity, risk-free rate, and volatility.

In the context of carried interest, these inputs will look like:

The Black-Scholes formula for a call option is:

In this formula, N refers to the normal distribution and:

Here, it is important to note that carried interest is a right to a percentage of the profits and not the entire profits. But the formula we have used will give us the call option value of the entire profits. So, we must multiply the call option value by the carry interest percentage to get the carry interest value.

Carried interest calculation example of Options Pricing Method

Suppose the fund’s value is $100 million, the hurdle rate is 2%, the remaining duration of the fund is 5 years, the risk-free rate is 3%, the volatility is 30% and the carried interest is 20% of the profits. So, our inputs will look like this:

• Fund Value (S)= $100 million
• Strike Price (K)= $102 million
• Time to Maturity (T)= 5 years
• Risk-Free Rate (r)= 3%
• Volatility (V)= 30%

By applying our formula, we can see that the approximate value of the call option will be $31.21 million. Now, we must multiply this by 20% (profit share under carried interest) to get the carried interest. So, the carried interest will be approximately $6.24 million.

While the Black-Scholes method delivers an actionable carried interest with very few assumptions, it is also highly dependent on the assumed volatility which itself is a very unpredictable factor.

Discounted Cash Flow Method

The discounted cash flow method involves estimating the future cash flows of the fund and discounting them based on a certain interest rate. Then, if the hurdle requirements are met, the fund managers will receive the carried interest.

Carried interest calculation example of Discounted Cash Flow Method

Suppose the initial investment in a fund is $500,000 and it is expected to grow to $1,500,000 in 5 years. We will also assume that the hurdle rate is 8%, the discount rate is 6%, and the carried interest is 20%. So, our inputs look like this:

So, the expected returns are $1,000,000. We can calculate its present value using the following formula:

So, the present value of the returns is $747,258.17. Let us see if this is more than the required returns as per the hurdle rate.

Required returns = Initial investment X ((1+Hurdle rate) Holding period – 1)
= $500,000 X ((1+0.08)5-1)
= $500,000 X 0.469328077
= $234,664.04

Since the present value of returns is more than the required returns, the carry interest will be paid on the excess profit.

Excess profit = Present value of returns – Required returns
= $747,258.17 – $234,664.04
= $512,594.13

Carried interest = 20% of excess profit
= 20% of $512,594.13
= $102,518.83

So, in this case, the carried interest of $102,518.83 will be allocated to the fund manager.

The two key assumptions in this method are the expected returns and discount rate. Since private equity investments can be quite volatile, the accurate assumption of the returns at the fund’s maturity is incredibly difficult to achieve.

On the other hand, the discount rate is based on expectations of the risk-free rate of return, which can shift with inflation and growth cycles.

Current Liquidation Method

The current liquidation method looks at the current market price of all assets held by the fund to estimate the profits and in turn, the carried interest. While this can be the most accurate method for calculating the carried interest, its application is quite limited in the context of private equity (PE) funds.

Often, in the early days, there will not be a market for the private equity held by a fund. So, this method can only be applied in the final years of the fund.

Strategies For Minimizing Taxes On Carried Interest

As a fund manager, when your compensation is structured as carried interest, the income will be treated as capital gains. Since the tax rate is lower on capital gains than on salaries and wages, this practice lowers the tax liability of the fund managers.

However, there are ways to further reduce the tax liability, which are:

Transferring carried interest

When you transfer your carried interest to your family members as a gift, the tax liability is calculated on the value of the carried interest on the date of transfer. So, you should consider transferring your carried interests before they accumulate returns. Another consideration is your track record in generating returns.

If you make the transfer before you develop a track record for generating returns, the valuation of the carried interest will be lower and hence, the tax liability will also be lower. Here, you must note the importance of getting an audit-ready valuation that also considers your tax concerns.

Holding period requirements

Before the Tax Cuts and Jobs Act (TCJA), carried interest was taxed at the long-term capital gains tax rate. After this act was passed, if you carried interest for less than 3 years, it would be treated as a short-term capital gain. Short-term capital gains are taxed at your regular income tax rates which can go up to 37%.

However, long-term capital gains are taxed at rates ranging from 0% to 20%. So, you should hold your carried interest for at least 3 years if you want to take full advantage of carried interest being treated as capital gains.

Structuring as partnership

By structuring your fund as a partnership, you get the benefit of pass-through treatment. Essentially, any income made by the partnership is directly transferred to the partners and then taxed. Thus, you can avoid instances of double taxation where you are paying a corporate tax as well as an income tax.

Case Study: Carried Interest Valuation

Zen Pro Inc. is a software company delivering products that seamlessly integrate into everyday life, enhancing productivity, efficiency, and overall user experience.

So, let us say that a company expects to generate an annual cash flow of $500,000 attributable to over the next 10 years and uses a discount rate of 15%, the present value of these future cash flows would be?

• PV – Sum of all the future discounted cash flows that the investment is expected to produce.
• CF – The overall cash flow for a given year. CF1 is for the first year and the CF2 is for the second year, and so on.
• r – The discount rate is in the decimal form. It is the target rate of return that you want on the investment.
• n – The number of years

With the present value of $2,509,384 and 3,000,000 shares outstanding, the value per share would be:

• Price Per Share  $2,509,384 / 3,000,000= $0.84

Benefits Of Engaging Professionals For Carried Interest Valuation

By engaging a professional valuation service provider like Eqvista, you are relying on a team that understands the complex nature of private equity to deliver a carried interest valuation that best represents your tax concerns. Some benefits of relying on professionals like Eqvista for carried interest valuation are:

Expertise and experience

A valuation professional is a finance specialist who has in-depth knowledge about their specialization and thus, can provide high-quality services.

One such valuation expert is Eqvista which has provided its services to more than 15,000 companies from various stages in their lifecycle.

Credibility

Since carried interest valuations are performed for tax purposes, the reputation of the valuer is of grave importance. You must choose someone with a track record of successfully providing audit-ready valuations.

Eqvista has been able to maintain its track record of reliable valuations thanks to our team which is made up of experienced NACVA-certified valuation analysts and accredited tax advisors.

Adherence to ethical standards

Trust is a very important factor in tax compliance. If your valuer is known not to act ethically, their valuations will come under suspicion, and you might suffer the consequences.

To provide reliable and unbiased valuations that can be defended against any level of scrutiny, Eqvista adheres to the highest ethical and professional standards.

Competitive advantage

As valuers gain experience and specialize, they will gain competitive advantages in their respective niches. You must choose a valuer whose niche aligns with your company’s characteristics.

In our experience of serving thousands of companies, Eqvista has developed an extensive and in-depth understanding of valuation methodologies and related laws, enabling us to better meet our clientele’s unique requirements.

Access to resources and networking

Valuation professionals work with investors and founders daily and hence, you can rely on them to introduce you to key players essential for your growth.

In addition to valuation services, Eqvista also provides cap table management solutions. We are also involved in connecting pre-seed and seed startups with investors through the Eqvista Raise initiative.

Minimize your taxes with Eqvista’s carried interest valuation!

Transferring your carried interests is an effective method for minimizing your tax liability. It has the potential to lower the taxable amount as well as the applicable tax rate. However, if the valuation of your carried interest is not tax-compliant or does not consider your tax concerns, it will be all for nothing.

As a professional valuation service provider, Eqvista can take this burden off your hands. We provide valuation services for fund-raising as well as tax-compliance purposes to private companies from various stages in their lifecycle.