What factors affect the valuation of carried interest?

Carried interest is the share of profit the general partners or fund managers will receive apart from their other forms of compensation. Though this definition looks simple, there are several requirements to consider for a company to have a carried interest.

To know what the fund managers can expect to receive based on the fund’s performance, professional valuers conduct the “carried interest valuation”. There are various factors affecting carried interest valuation, including the investment duration, fund performance, management fees, etc.

Carried interest valuation

Fund managers often earn carried interest, or “carry”, as a performance fee in addition to their base salary and operating expenses. Carried interest is a compensation structure that aligns the fund manager’s interest with their fund returns.

Fund managers normally receive 20% of the company’s profits when they earn more than the minimum limit, called the “hurdle rate”.

The general partners will also receive a 2% fixed charge annually as a management fee. Carried interest is not fixed but purely based on the fund’s performance. Also, general partners only receive carried interest once they have distributed the initial investment and earnings to limited partners.

Additionally, carried interest is taxable as long-term capital gains with a maximum of 20%. An investment’s bare minimum holding period needed to be eligible for long-term capital gain treatment of related carried interest is three years.

How is carried interest calculated?

Carried Interest is calculated as a percentage of the fund’s profits exceeding a certain hurdle rate, a predetermined minimum return threshold.

Here’s a breakdown of the calculation process:

• Hurdle Rate – The hurdle rate is the minimum acceptable return for the fund’s investors. Until this rate is met, the fund manager doesn’t receive any carried interest.
• Profits Above Hurdle Rate – Once the fund’s profits exceed the hurdle rate, the carried interest is calculated on the remaining amount. This signifies the excess profit generated by the general partner’s investment decisions.
• Carried Interest Rate – A fixed percentage, typically around 20%, is predetermined in the fund’s partnership agreement. This rate is applied to the profits exceeding the hurdle rate.

Example of carried interest calculation

Suppose a private equity fund has the following parameters:

• Initial capital invested by LPs – $100 million
• Total return generated by the fund – $150 million
• Preferred return (hurdle rate) – 8%
• Carried interest percentage – 20%

Let’s follow the steps to calculate the carried interest:

Calculate Total Profit:

• Total profit = Total return – Initial capital invested by Limited Partners
• Total profit = $150 million – $100 million = $50 million

Calculate Preferred Return:

• Preferred return = Initial capital * Hurdle rate
• Preferred return = $100 million * 8% = $8 million
• Remaining profit = Total profit – Preferred return
• Remaining profit = $50 million – $8 million = $42 million

Calculate Carried Interest:

• Carried interest = Remaining profit * Carried interest percentage
• Carried interest = $42 million * 20% = $8.4 million

In this example, the general partners would receive $8.4 million as carried interest, and the LPs would receive the remaining profit after the preferred return and carried interest distribution.

Factors affecting carried interest valuation

Compared to the value of an interest in a regular operating company or business, the carried interest valuation in a private equity (PE) and venture capital (VC) fund is more complicated and requires different factors. The following are some of the important factors impacting the carried interest valuation.

• Fund performance – Unlike base pay, carried interest solely depends on fund performance. The general partners will often look for companies that have the potential to profit from the funds. The carried interest valuation will be higher in proportion to the increase in the fund’s performance. If the fund performance is low, the carried interest valuation will also be lower.
• Market conditions – Economic conditions, market fluctuations, and industry trends can greatly influence carried interest valuation. The bull market normally leads to higher valuation because of increased asset appreciation.
• Exit strategy – If the portfolio companies’ exit strategies work, the carried interest valuation will go up. One way out is through a secondary sale to private equity or venture capital; another is through an initial public offering (IPO). A well-planned exit strategy can improve the worth of the carried interest.
• Management fees – Management fees cover the fund’s administrative and operational expenses. If they are higher, they can cause disputes among investors, affect the company’s overall performance, and lead to lower carried interest valuation.
• Allocation waterfalls – A waterfall chart shows how positive and negative intermediate values influence a starting value to yield a final value. Waterfall charts often help analyze sequential data, proving beneficial when seeking VC funding.
• Return assumptions – Do you know that assuming about the fund’s performance and its return can affect the carried interest valuation? As the carried interest calculation is for the future, we might use unrealistic discounts or percentages being too optimistic or pessimistic.
• Rights and preferences – The carried interest valuation may be impacted by the fund’s partnership agreement and the decisions and rights of limited and general partners.

Common Performance Metrics Used to Determine Carried Interest

It is common to utilize the following performance metrics to calculate carried interest. This ensures a precise assessment of the fund manager’s share based on the fund’s performance.

Internal Rate of Return (IRR)

The IRR is an important metric for assessing carried interest. It considers the timing and amount of cash flow you receive from the investment. The IRR shows how well an investment performs for any project or fund over time. It calculates the rate of growth the investment is experiencing.

Let’s evaluate a private equity fund with the following cash flows over a five-year period:

• Initial Investment (Year 0) – -$5,000,000
• Year 1 Cash Flow – $500,000
• Year 2 Cash Flow – $1,000,000
• Year 3 Cash Flow – $1,500,000
• Year 4 Cash Flow – $2,000,000
• Year 5 Cash Flow – $6,000,000 (including proceeds from the sale of the investment)

Calculation of IRR

The IRR is the discount rate that makes the Net Present Value (NPV) of these cash flows equal to zero. The formula is:

0=-5,000,000+500,000/​(1+r) +1,000,000/(1+r)2​+1,500,000/(1+r)3 + 2,000,000/(1+r)4​ + 6,000,000/(1+r)5​​

To find r (the IRR), we can use Excel or a financial calculator and we will get an IRR of around 22.5%. This signifies that the PE fund achieved a return of 22.5% per year on their investment, considering the cash flows received at different points in time.

Total Value to Paid-In (TVPI)

TVPI is a measure that lets you know the total value of the investment relative to how much money you have put in. It considers both the investment’s current value and distributions received, if any.

Consider an example ,an investor commits $1 million to a private equity fund. Over time, the fund invests, generating $1.5 million in distributions, with remaining investments valued at $2 million.

TVPI = (Distributed Cash + Unrealized Value) / Initial Investment
= ($1.5 million + $2 million) / $1 million
= $3.5 million / $1 million
= 3.5x

So, the TVPI for this investment is 3.5x, indicating that for every dollar invested, the investor has received $3.5 in total value (both distributed cash and unrealized value).

Multiple on Invested Capital (MOIC)

In private markets, multiple on Invested Capital, or MOIC, is a measure that characterizes the performance or value of an investment relative to its original cost. It is among the most essential measurements to evaluate when performing fund due diligence. In fund investments, MOIC is the total value (realized and unrealized) of all shares in the fund divided by the original investment.

For example a Private Equity Fund has an initial investment of $1 million. Over time, the fund makes multiple investments. After several years, the fund exits one of its investments, receiving $5 million in returns.

MOIC = Total Returns / Initial Investment
= $5 million / $1 million
= 5x

So, the MOIC for this investment is 5x, indicating that the fund generated five times the initial investment amount in returns.

Distribution to Paid-In Capital (DPI)

The Distribution to Paid-In Capital (DPI) measures the total capital a private equity firm has returned to investors. Its stated goal is to provide a rough assessment of the return on investment that investors have seen in the meantime.

Suppose A venture capital fund receives $2 million from an investor. After investing in startups, the fund distributes $1.5 million to the investor from successful exits and partial distributions.

DPI = Distributed Cash / Initial Investment
= $1.5 million / $2 million
= 0.75

So, the DPI for this investment is 0.75, indicating that the fund has distributed 75% of the initial investment back to the investor.

How Eqvista can help with your Company’s Carried Interest Valuation

The initial step before providing carried interest to the general partners involves securing funds from them, necessitating a business valuation for the company. This is where Eqvista can support you.

Eqvista provides comprehensive solutions to help with carried interest calculation for private equity firms and fund managers.

Our experts offer carried interest valuation services to accurately determine the present value of carried interest based on various methodologies like:

• Current Liquidation Scenario – This simulates an immediate fund liquidation to calculate the carried interest value based on current investment values.
• Monte Carlo Simulations – This method is a powerful tool. It uses simulations to estimate carried interest value by modeling different possible performance outcomes for the fund. This helps to make decisions based on a range of potential scenarios.

Eqvista’s valuation experts ensure compliance with regulatory standards and fair compensation tied to fund performance. By leveraging Eqvista’s advanced valuation software and expertise, companies can better position themselves to present compelling, data-driven insights to investors and prove their worth.

Carried Interest Valuation with Eqvista!

With our professionals’ support, you can mitigate the complexities of fundraising with ease. To know more about our valuation services, contact us Today!

Valuing carried interests requires specialized methodologies like DCF or option pricing models, careful consideration of fund-specific factors, supportable assumptions, and thorough documentation to withstand regulatory scrutiny.

By leveraging Eqvista’s valuation services, private equity firms and individuals can obtain well-supported and defensible carried interest valuations, benefiting from their specialized knowledge, rigorous methodologies, and comprehensive documentation.