The value of success

The challenge: 

With changes made to the UK’s Qualifying Partnership legislation, many carried interest partnerships will be required to prepare and file accounts. If the partnership’s interest in the fund is carried at fair value, how could that be estimated? 

Richard Bibby’s answer:  

Valuing a private equity fund’s investments can be a challenge in itself without having to consider the fair value of the carried interest as well. This will need to be overcome for those beneficiaries who may wish to transfer their rights or even record the fair value in the financial statements of the carry vehicle, which may become more likely following the changes to the UK Qualifying Partnership regulations.

Managers like carry structures as the details are not generally public knowledge, payments of carry are often more tax efficient than other forms of remuneration and the rewards for good performance can be substantial. So how does one go about valuing the potential future profit on a fund’s investments? 

The structure of the carried interest is very similar to an earnout or an option given the payout usually depends on the future value of the investment(s) achieving a hurdle price over a certain timeframe. 

CFOs, especially those with public company experience, will know that ASC 718 (FAS 123)/IFRS 2 indicates suitable methodologies for valuing share options with a strong preference for models such as Black-Scholes, binomial or other lattice structures. The preference for these models in those circumstances is that the input data tends to be more readily observable for listed companies, in particular the volatility of the underlying investment. 

Limitations of such methods are also relevant: 

• It is impossible to test the volatility of private companies as there are rarely intermediate transactional reference points between acquisition and disposal. 

• Models assume a liquid market in the carry – there is rarely such ability in private equity and therefore transactions that do occur may well be at a discount to a model derived calculation given there is often insufficient competitive tension for the buyer to match such a price. 

That is not to say option methodology cannot be applied to valuing carry however the outputs of the models are only as good as the inputs; hence caution should be made when applying option methodologies to carry valuations.

Alternative methods, which tend to be easier to follow but nevertheless retain a significant degree of subjectivity include a simple discounted cash flow (DCF) or, in a more sophisticated approach, a probability weighted series of DCFs based on a number of modeled scenario outcomes (e.g. A% of £X, B% of £Y, C% of £Z etc.). Again the inputs to these assessments, including the forecast cash flows, discount rate and probabilities are all subjective and should be exercised with caution.

Whichever approach is taken, the principles adopted are the same as for any investment, including the valuation of the portfolio companies of the private equity house. Accounting fair value represents the price a willing buyer would be prepared to pay for the asset; understanding the risks and rewards associated with the investment decision will go a long way to establishing the appropriate value, irrespective of the method adopted.