Given the complexity involved, how should GPs value the various profits interests for entities organized as LLCs (Limited Liability Companies)?
Robert Barnett’s response:
The valuation of profits interests is an area of interest for private equity investments structured as LLCs that provide for classes of incentive units to be held by retained management and other stakeholders of interest. Their valuation is a two-part process. The first part requires valuing the total equity of the LLC using traditional valuation approaches, most often income and market approaches. The second part values the classes of profits interests through an option pricing framework. To value profits interests, it is critical to understand why they should be modeled as options. The fundamental answer lies in the relationship between capital units and incentive units.
Capital units are the economic substance of an LLC’s equity. The capital units are a representation of contributed capital at the time of formation and upon future equity investment. Upon a future liquidity event the capital units receive, in preference to all classes of profits interests, the original committed capital and a preferred return provided enough equity value is available. After such priority, the profits interests may receive distributions on a pro rata basis with the capital units. It is the payoff mechanism associated with the profits interest that makes an option-pricing approach the correct one and the valuation methodology a volatility/time model, not a discounted cash flow. The larger implication is the irrelevance of the required rate of return which fits with the nature of these securities having no contributed capital.
Participation by profits interests is dependent upon vesting criteria. Time-vesting provides that the profits interests will immediately receive value once the capital units have been returned the original commitment and the yield on that capital. Performance-vesting provides for participation once the capital units have received progressively higher targeted returns. The vesting terms imply strike prices based on the priority of returns to the capital units.
Since profits interests do not technically pay a strike price to acquire a unit – they simply receive an equity distribution if available – they are valued in the context of total equity. Thus, the option pricing model must work with the current capitalization table. Based on the outstanding capital units and classes of profits interests, a model framework must behave dynamically to capture an ending fully-diluted unit count that is a function of the ending equity value. This variability is driven by the vested versus unvested classes of profits interests.
A valuation model must do three things: (1) incorporate multiple classes of profits interests based on ending equity values, (2) incorporate vesting requirements through implied strike prices, and (3) model the distribution of ending equity values based on the volatility and term inputs. Numerical methods – primarily Monte Carlo simulation – are well suited to handling all three of these elements. These methods have the advantage of beginning with the end in mind; that is they start with an ending equity value and can tailor the equity participation accordingly. This is a necessity when valuing profits interests.
A familiar framework
The key insight to understanding profits interests is that they are options by another name; therefore, the concepts applicable to valuing an option are applicable to valuing a class of incentive units. Valuing profits interests simply requires that the valuator apply what is already known about option valuation, but in a parallel framework that looks at all the traditional option inputs in a similar but slightly altered manner. Also, recognize that the valuation complexity is driven more by detail than concept. The equity-value dependent nature of the classes of profits interests is best suited to a numerical method that employs established option pricing principles and incorporates the numerous participation thresholds with respect to the capital units and performance vesting.
This is an important question for many private equity firms. For example, a portfolio company may be capitalized by the private equity firm combined with smaller equity investments from management or other parties as well as debt financing. This equity structure is frequently populated by capital units and incentive units. Units are the “shares” in an LLC. The incentive units represent profits interests and are analogous to stock options.
The valuation of profits interests requires a two-part discussion. The first part is the aggregate valuation of the enterprise or the LLC itself through traditional methods. An estimate of the total equity value is made giving appropriate consideration of debt. The second part considers the values of the individual capital and incentive units in the context of this total equity value. Generally this incentive class is valued using an option-pricing model.
However, there can be several complicating nuances. The nature of profits interests usually requires a more generalized application, but one common approach is a multi-layered application of the Black-Scholes formula. This approach requires a simple external correction or adjustment. A Black Scholes model – or any option pricing model – requires five basic inputs (and may include a sixth if dividends are expected). Let’s consider each with respect to incentive units or profits interests:
Stock price – An incentive unit is not derivative of another share of stock like a stock option. It is instead a derivative of the company’s total equity value vis-à-vis the capital units. The stock price then must be the company’s total equity value.
Strike price – There are implied strike prices that allow the option-pricing approach that consist of the capital units’ contributed capital plus preferred return as well as participation thresholds associated with equity returns to the capital units. These thresholds represent performance vesting conditions for the incentive unit classes.
Term – Incentive units do not have a contractual life like an option so the term is the expected timing of a future liquidity event (M&A or IPO).
Volatility – Profits interest are the most volatile equity class of units in an LLC since their access to distributions is limited to upside valuations of the equity. Leverage should be considered as LLCs generally have a greater leverage ratio than other industry participants.
Risk free rate – the appropriate discount rate in an option-pricing model measured for a holding period commensurate with the expected term or time to liquidity.
Dividend – While there is generally no dividend yield, there is frequently a preferred return afforded to the capital units which serve to reduce the total equity value, but also lower the participation thresholds for all classes of incentive units.
The discussion around the inputs to an option pricing approach highlights the unique aspects of profits interests and the similarities of this class of equity to an option. It is the payoff mechanism associated with the profits interest that makes an option-pricing approach the correct one and the valuation methodology a volatility/time model, not a discounted cash flow. The larger implication is the irrelevance of the required rate of return which fits with the nature of these securities having no contributed capital.
Robert Barnett is a managing director at the Valuation Research Corporation.