FROM THE FOUNDATION PRESIDENT
Happy New Year! Welcome to the second issue of Forensic and Business Valuation News and Views.
Let’s start out the year with a hypothetical: You represent the spouse of someone who invested, with your client’s prior knowledge and consent, $1,000,000 of community or marital property (depending the state in which your practice is located) in a private equity investment partnership. The joint funds were invested one year ago, and by the terms of the partnership the payout to investors is to be completed 10 years from the inception of the fund (nine years from now). There is a “guaranteed” return of 8%, to be paid at the end of year 8. But if the fund performs as expected, there will be a return of far more than that by the end of year 10. There is no dispute that the investment is community or marital property. The larger increment – and the reason that people invest in private equity funds such as this one – is the so-called “carried interest.”
Your client can, of course, “stay in” and split the return – whatever it is – at the end of 10 years. But let’s suppose that your client does not have the same tolerance for risk as the spouse who made the investment (see, for example, In re Marriage of Burkle (Burkle II) (2006) 139 Cal.App.4th 712) or just does not want to wait nine years to cash out. So now you’re thinking about awarding the investment to the “investor” spouse at its current value, as would be the case with a piece of real estate or a business that is awarded to one spouse rather than left in co-ownership.
But wait! This isn’t a house or a business. It’s not even a pension that can be valued and awarded to one spouse (even though that happens a lot less often now than it did 50 years ago).
The present value of the 8% return is easy for your friendly forensic to determine, but what about the carried interest? That’s the big number. So before you put your client into a settlement whereby he or she receives a lump sum for half the carried interest, the amount of which has not yet been determined, you better make sure that it’s valued properly. You also need to be sure that you know enough about how the payout is determined to be able to explain it clearly to your client.
That is the subject of this issue’s article by Forensic and Business Valuation Division Member Vlad Korobov, “Carried Interest: What It Represents and How to Value It.” Vlad not only explains how you (or, let’s face it, your expert) should “crunch the numbers,” he gives us an example of how it’s done.
Here’s why you need to get it right: After entering into a postnuptial agreement to have her husband cash her out of a number of high-dollar, high-risk investments, upon divorce the wife in Burkle, supra, saw how much he had made from them and tried to get the court’s permission to change her mind. The California Court of Appeal held that she could not get a “do-over.”
We know you’ll enjoy Vlad’s article and hope you’ll find it useful.
With warm regards,
Lawrence A. Moskowitz
AAML Foundation President
CARRIED INTEREST: WHAT IT REPRESENTS AND HOW (BEST) TO VALUE IT
Vladimir V. Korobov, CPA, ABV, ASA
What is Carried Interest?
What is Carried Interest?As a type of incentive compensation, carried interest and similar profit-sharing arrangements [1] have been around for a long time. The notion of carried interest dates back to medieval times and relates to the share of profits that ship captains received on the cargo they carried.
Carried interest has been a staple of the private equity and venture capital industries in the United States for many years.
How It Works
Carried interest typically represents a share of proceeds from a sale of a portfolio investment, which is determined using the proceeds allocation formula (often referred to as a “waterfall”) specified in an investment fund’s formational document, such as a partnership agreement. Following is an example of a typical waterfall used in private equity and venture capital funds:
Initial Allocation: Proceeds from the sale of a portfolio investment are initially allocated pro rata between a general partner (“GP”) and the limited partners (“LPs”) based on the partners’ respective capital contribution percentages.
Second Allocation: Proceeds initially allocated to the LPs are then re-allocated between the LPs and a GP as follows:
- Step 1, Return of Capital – First, 100% to LPs until LPs have recouped their capital contributions used to fund portfolio investments, fees and expenses;
- Step 2, Preferred Return – Then, 100% to LPs until LPs have earned an 8% return (compounded annually) on their capital contributions;
- Step 3, GP Catch Up – Then, 100% to a GP until the GP has received 20% of the amount distributed to the LPs in Step 2; and
- Step 4, Residual Split – Thereafter, 80% to the LPs and 20% to the GP.
The GP’s right to receive distributions under Steps 3 and 4 above represents the GP’s carried interest in the investment fund.
Why Value Carried Interest?
If an investment fund is successful, carried interest can generate significant distributions to a holder over the fund’s life. It is not a surprise then that a question of valuation of carried interest often becomes a hot issue in a divorce.
When “Value” May Not Be Value
Readers may ask: “If a GP of the fund determines the values of the fund’s investments as of a given date and calculates the amount of a carried interest distribution, if any, that the GP would receive upon a hypothetical liquidation of the fund’s investments at those values, wouldn’t the amount of the distribution represent the value of the GP’ carried interest on that date?” The answer, in most cases, is generally no for at least three reasons.
First, a hypothetical liquidation scenario does not capture any potential value of a fund’s “dry powder,” i.e. remaining capital commitments. This potential value is highest at the earlier stages of a fund’s life. Second, the hypothetical liquidation scenario does not reflect the time value of money. Third, carried interest effectively represents a call option on a share of the fund’s profits over the investors’ preferred return. Thus, the hypothetical liquidation scenario does not consider a potential for future appreciation of the value of the investments, i.e., the time value of the call option, which can be significant in the early stages of the fund’s term.
Carried Interest Valuation
If the hypothetical liquidation scenario is not the right answer to the question of value of a carried interest in most cases, then what is? The right answer is the present value of the expected cash flow, or the carried interest distributions expected to be received over the life of the fund. The present value can be determined utilizing either an option-pricing framework, or a discounted cash flow method. In this essay, we will illustrate a valuation analysis using the discounted cash flow method.
Let us consider the following scenario. A private equity firm has just raised a new fund with $1 billion of investor commitments. The GP of the fund has committed 1.0% of the investor commitments, or $10.0 million. The fund has a term of 10 years, which is divided into the investment period (the first five years) and the investment exit period (the last five years). Based on experience with earlier funds, the GP expects an average holding period for investments to be 5 years, and believes that the fund could realize value of 2 times invested capital. The GP estimates the following capital drawdown schedule during the investment period:[2
Based on the estimated capital drawdown schedule, the expected holding period, and the targeted performance of 2 times invested capital, we can develop a forecast of cash flow over the fund’s term:
We can then allocate the projected proceeds between the general partner and limited partners using the typical waterfall presented earlier:
Now that we have identified the future carried interest distributions – specifically, the distributions to the GP in Steps 3 and 4 — we can determine the value of the carried interest as the present value of the projected carried interest distributions. Assuming an income tax rate of 23.8% and a discount rate of 20%, the value of the carried interest would be $28.0 million, as calculated in the following table:
[1] An example of a profit sharing arrangement similar to a carried interest is a developer’s promote in a real estate development project.
[2] For purposes of this illustration, we will disregard management and other fees that limited partners may be subject to.
[3] The income tax rate consists of the federal long-term capital gain tax rate of 20% and the net investment income tax of 3.8%. For illustration purposes, we assumed that the carried interest distributions would not be subject to the state income taxes.
VLADIMIR V. KOROBOV, CPA, ABV, ASA, is a partner at Marcum LLP in the Valuation and Litigation Support Services group. He has more than 20 years of experience providing business valuation, litigation support, and advisory services with a focus on alternative and traditional asset management, and financial institutions.
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