Calculating carry

When accountants look at the way a fund structures carried interest payments, one significant question they must ask is if carry will be recognised and if so at what point. 

There are some important points to consider before deciding on the answer of this question – when to start accounting for carry – whether to recognise/accrue for it earlier in the life of the fund or to wait until actual cash payment is made. There are also some obvious triggers that would provide good pointers about when to recognise carried interest.

The first trigger point is when the value of the assets is higher than the outstanding loan account (in UK funds) or the capital-contributions account (in US funds) and past the hurdle. Although the fair value of the private equity investments, which accounts for most of the net asset value (NAV) of the fund is highly hypothetical and subjective, this is a time to consider accounting for carry. This is based on the same assumption, mentioned above, namely that the partnership is liquidated/wound up on the reporting date and it had realised all assets and settled all liabilities at the fair value reported in the financial statements, and then allocated all gains and losses and distributed the net assets to each class of partner at the reporting date in accordance with its LPA provisions. Since the NAV of the fund is sufficiently high to hypothetically pay out carried interest to the carried interest partners (CIP), and because of the accrual concept, it is time to consider accounting for carry. Before that point, there is no need to do anything in terms of accounting, although it would be a good idea to start modeling the carry and testing it in preparation for that trigger point.

Mariya Stefanova

The second trigger point is when the loan-contributions account (in UK funds) or capital-contributions account (in US funds) plus the hurdle has been repaid to the LPs, after which point 20 percent of all the proceeds (essentially the carried interest) is due to the CIP, in which case this means that in most of the cases there would probably be little choice but to account for it.

With regards to the period between the two trigger points, there are two potential arguments with two accounting approaches, discussion of which follows.

FIRST APPROACH: NO LIABILITY, NO RECOGNITION APPROACH 

This first approach is more in line with International Financial Reporting Standards (IFRS), but some argue that the second approach is also in line with IFRS, so I will leave it to you to decide which approach you adopt, depending on which arguments seem more convincing and of course subject to your auditor’s approval.

Unfortunately, for IFRS (and the same goes for UK GAAP) there is no guidance specific to private equity or at least generally to investment entities such as that provided by the American Institute of Certified Public Accountants (AICPA) for US GAAP, which informs exactly when to recognise or how to account for or present carry in the financial statements.

Back to the first approach: before the first trigger point, do not do anything, but monitor and make sure that the fund is not past that theoretical threshold.

For the period between trigger point one and two as explained above, the CIP can, hypothetically, start allocating carry based on the assumption that all the partnership’s assets are realised on the reporting date at the assets’ fair value, past the hurdle. However, the partnership’s investments are usually not marketable or feature limited liquidity that interim valuations are highly subjective. Therefore, the argument that recognition needs to be delayed until gains can be measured objectively, or to put it in a different way, if the assets are realised (hypothetically) and they are realised at that value (that is, the fair value which is another hypothesis), then the carry partner will receive that amount, but that is just a hypothesis and there is no liability to the CIP based on that hypothesis.

Accordingly, considering the highly subjective nature of private equity valuations and that carry is not due to the CIP, that is, this is not a liability, the argument follows that carried interest cannot be put through the accounts.

However, for those for whom this argument seems appealing, it would be very useful if there is a disclosure note in the notes to the financial statements, such as a ‘contingency’ note but not a ‘contingent liability’ note as it cannot be a liability. Such a note could read as follows: ‘In the event that all the assets were sold at that carrying value, an amount of £X million will be payable to the carried interest partner.’

Bear in mind that this is a very important piece of information for the investors. My recommendation would be that you make your waterfall calculation at that point in time and you run the numbers through your waterfall model and make this disclosure based on the output from the model in the notes to the accounts.

After the second trigger point, as explained above, in most of the cases there would not be much choice but to account for it, that is, either, to reallocate 20 percent of the profits realised due to the CIP (a liability at that point) from the LPs to the CIP as it has been previously treated by many funds, or as an expense, if you chose to follow a relatively recent official treatment recommended by the Big Four accountancy firms as explained in the next paragraph; reallocate 20 percent of the net assets from the LPs to the CIP and of course account for the cash distribution in line with the cash waterfall.

What I will say now may sound as a bit of a surprise (and not a pleasant one) to some of you that may call for a change in your treatment of carried interest. Traditionally, as explained earlier, even under IFRS, carried interest has been treated as a reallocation of profit/gain, but now all the technical experts at the Big Four accountancy firms have agreed that carried interest under IFRS is to be treated as an expense. What, for example PricewaterhouseCoopers states in one of its publications is “unlike US GAAP where a carried interest may be presented as an allocation, a carried interest under IFRS will always be reflected as an expense (when the appropriately thresholds have been met)”, that is after the second trigger point which is past hurdle. 

The argument, despite the legal form, is basically that: “A service is rendered by the GP, which gives rise to a financial liability (with a corresponding expense) as soon as the service is rendered as the obligation to pay meets the definition of financial liability in IAS 39 (obligation to deliver cash arising under a contractual agreement) and such obligation being recorded in income statement.” I would say that this argument has its merits, after all, despite the fact that carry has been traditionally structured by the lawyers in your LPAs as a profit share, not a consideration in exchange for a service rendered by the CIP to the fund, we all know what the carried interest is in essence, plain and simple – a performance fee.

SECOND APPROACH: THE ACCRUAL APPROACH 

The counter argument is that when accountants prepare accounts, we prepare them on an accrual basis, on the basis of prudence and looking forward. If the assets are sold at that value, and the valuation is in excess of the outstanding loan, the relevant proportion should go to the CIP. If the valuation exceeds the amount of the outstanding loans, this excess amount (which is in revaluation reserve) is allocated to the CIP.

There is usually a single revaluation reserve, so a good approach would be to split the revaluation reserve into ‘revaluation reserve’ and ‘carry reserve’/’provision for carry’ (or anything that you deem appropriate that would make best sense to the investors), which is allocated to the relevant classes of partners, that is, the LPs and the CIP, respectively.

If accounted for under this accrual approach, this is all that is required when accounting for carry at this point – split of the excess revaluation reserve by class of partners in the partners’ accounts and still no liability to the CIP.

Keep in mind that this is a tax-sensitive issue and you may want to think carefully about the presentation in the accounts as the relevant tax authorities may be tempted to follow your accounting treatment and presentation. After the second trigger point, it should be similar to the first approach, that is, to account for carry in the majority of the cases.