Why should GPs consider transferring carry?
With interest rates currently at record lows, and private funds generating strong returns, now is an ideal time for GPs to review their estate planning so as to pass on wealth with minimal estate and gift taxes. Taxes are imposed on the transfer of assets in life or at death, but individuals are entitled to pass on a certain amount without incurring taxes. Carried interest represents a unique transfer planning opportunity for GPs because at the start of a fund, it has no realized value, but if the fund is successful, its value could potentially be substantial. We increasingly see people gifting that carried interest in a fund to a family member or more often to an entity, such as a trust.
What are the first steps GPs should take if they want to make a transfer?
Valuing the carried interest for both private equity funds and hedge funds is a complicated assignment, but before seeking a valuation, it’s important that the fund partner first works closely with an estate planning attorney and a tax accountant to determine the best option for structuring the gift. There are unique and complex regulations that apply to the transfer of carried interest, including a rule that says a fund manager must transfer not only his or her carried interest, but also a proportionate amount of all the manager's other equity interests in the fund. This is known as a “vertical slice”, and might include a percentage interest in the capital interest and any related obligation to contribute capital. The law says GPs must transfer a bit of all their interests, and so it is important that proper advice is sought even before work begins on a valuation.
When is the best time to do a transfer?
It is best to do the valuation and transfer very early on in the life of a fund because the capital has not been deployed at that point, or a minimal amount has been, and so the future gains or proceeds are more uncertain than they might be a few years down the line. When there is a track record, we can see how the investments are performing and the fund will have started realising returns. The future value of the carried interest is most uncertain and risky at the beginning of the fund, and essentially as the fund gets older – assuming the assets are performing – the value goes up. So we recommend carrying out the valuation soon after closing the fund, once it is clear what the commitments are, but before investments have been made.
How do you go about valuing carried interest?
A fund isn’t like a manufacturing company – you can’t project market returns in the same way that you can project widget sales volumes. So once the partner knows how they will be structuring the transfer and what they need valued, we use complex option pricing models and simulations to value the carried interest and capture the future market returns.
Because these funds are at such an early stage, we employ an “income approach” of valuation, which means we consider a discounted cash flow analysis, projecting the investments that will be made and the likely returns on those investments.
Are simulations used when conducting the valuation?
It is best practice to use the Monte Carlo simulation to develop a robust discounted cashflow model. That means rather than just assuming a flat rate of return across the investments in the fund, or even various different rate of return scenarios, the simulation will capture factors like historical market volatility.
We see what the fund has identified as benchmarks in the case of hedge funds, or if it is a private equity fund we look at volatility of the underlying industries in which the fund is investing, and we use that information to create a simulated return on the fund or the investment.
Why are simulations so important? Why can’t a flat rate of return be assumed?
We believe that simulation is absolutely the best way to value carried interest, and when a private equity professional is looking to do this type of gifting, they need to make sure the professional they are working with is using a simulation methodology. It is key because if you are doing the valuation early in the fund’s life, a simulation considers the ups and downs of the wider market, so it will most likely result in a more appropriate valuation than just assuming a flat rate of growth. Without a simulation method, there’s a risk that the value will be overstated.
The other advantage of simulation is supportability. A simulation captures more ups and downs, which is a lot more realistic than a flat rate of growth. These assumptions are more realistic and supportable than a flat rate of growth if the valuation is ever challenged.
What information do you need to conduct a valuation?
Fund managers need to be prepared to talk about previous funds if there are any, and to provide historic information on their fund results. They need to be prepared to discuss their expectations for the current fund, from investment dates to holding periods, and if it’s a general fund, a valuation professional will need an idea about what industries the investors are interested in so that they can start to develop the story.
We spend a lot of time upfront developing that story and supporting that, so we are not just talking about a private equity fund doing five investments over five years in medtech, but instead we are looking at why that is the strategy, what size the investments are going to be, how long they will be held, the history of the individuals involved, how past funds have performed compared to the market, and so on.
How long will it take to get a valuation?
We work closely with fund management to develop assumptions that reflect history with previous funds and the current environment. There is always a bit of back and forth to gather the information required to arrive at the most supportable assumptions. It takes longer to value a private equity fund than it does a hedge fund because a hedge fund will already be using the concept of benchmarking, and is not as illiquid as a private equity fund tends to be. So for a private equity fund, it can take up to two or three months to finalise a valuation based on the depth of discussions to develop the assumptions. Any professional will work closely with fund management to ensure deadlines are met.
Is now a good time to do this?
Yes. Obviously the tax rules are always changing, but there are multiple rules that govern these transfers, some of which are currently under review. If you are a professional looking to do some transfer planning, and carried interest may play a part in that, my advice is to get it done. Now is a good time to keep your estate planning moving forward, and we think that gifting carry makes a lot of sense versus other interests in funds because of the potential for significant increases in value as the fund matures.
Lindsay Hill has 10 years experience at RSM advising companies on valuation and finance-related issues for financial reporting, management planning, and tax planning and reporting. She specialises in valuing private equity and venture capital positions, including equity, debt, preferred stock, option and other derivative positions.
This article is sponsored by RSM. It appeared in the 2016 Yearbook published with the December 2106 issue of pfm