Carried Interest refers to the fund manager’s incentive interest in an alternative investment fund, typically contingent on meeting key performance benchmarks. When gifting a percentage of their carry, fund managers are often required under Internal Revenue Code Section 2701 to also gift the proportional ownership percentage of their fund capital contribution—commonly known as the “vertical slice.”
We’ll examine the nuances related to the valuation of the carry component and identify common pressure points in the valuation process that may attract IRS scrutiny during an audit. While IRS audits of general partner interests are rare, understanding the key inputs and assumptions driving a carry valuation is critical.
Many appraisers use a discounted cash flow analysis to determine the value of carry. Below are key factors to consider when reviewing a carry DCF analysis:
Accurate Allocation of Cash Distributions
Most funds have a limited partnership agreement (LPA) defining the timing and quantity of distributions to fund partners. Incorrectly modeling a fund’s distribution based on the terms of the LPA can result in errors and potentially trigger IRS scrutiny and even penalties. For example, if the waterfall doesn’t capture a changing pro-rata allocation of cash flows between the GP and limited partners on satisfying certain return thresholds (as defined in the LPA), the waterfall model may contain errors.
Common Fund Distribution Structures
European waterfall: Carry is allocated based on the aggregate capital appreciation of the fund’s entire portfolio. An LPA may read “aggregate distributions with respect to all portfolio investments.”
American waterfall: Each individual investment’s performance determines the allocation and distribution of carry. An LPA may state “distributions with respect to a portfolio investment.”
Time period crystallization: Allocations are based on a specified time interval. For instance, many hedge funds allocate carry to the fund manager on Dec. 31 of each year based on the portfolio’s realized and unrealized gains.
Forecasting Fund Cash Flows
Key assumptions in a fund’s forecast should be compared to benchmarks and prior fund performance. Generally, fund managers provide fund statistics from prior investments for use in the current analysis. Large deviations from historical and benchmark performances should be carefully assessed and justified. Below are some forecast assumptions:
The percentage of fund capital invested each year.
Liquidation time horizon of each fund.
Projected internal rate of return for each investment in the fund (sometimes measured as multiple of invested capital)
Selecting Discount Rate
A DCF is commonly used to determine the fair market value of the carry. Appraisers may discount projected fund cash flows and allocate them to the partners of the fund. Alternatively, the GP’s cash flows may be directly discounted. These two cash flows often have different risks, requiring different discount rates. Using a fund-level discount rate for determining the FMV of carry cash flows may impact the validity of the analysis and invite IRS scrutiny.
Applying Appropriate DLOM
The discount for lack of marketability that’s applied to a GP interest requires careful consideration of the fund’s liquidation schedule and volatility.
Appraisers often rely on restricted stock studies to support the concluded DLOM. Tax courts, however, argued that the selected DLOM should apply to the facts and circumstances of the interest valued. Using a general restricted stock study, which measures average DLOMs over a basket of restricted stock or pre-IPO companies without considering each investment in the study relative to the carry, could result in a lack of comparability to the specific investment being valued.
Appraisers often use option models to develop a DLOM. Matching a put option model to a carry interest can be challenging. The fund’s underlying assumptions should support key option model inputs like term and volatility.
Volatility is another key input in the DLOM calculation. The selected volatility of the projected cash flow stream should reflect the interest’s volatility. Otherwise, it may invite scrutiny. When using a carry cash flow, the volatility should apply to the expected volatility of the carry. When using a fund cash flow, the volatility should reflect the fund’s volatility.
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