Carried interest entitles a private equity fund’s general partner, which itself may be a partnership of several entities or individuals, to receive a share of the fund’s profits, usually after the fund exceeds a certain return. The tricky part comes when a company needs to put a present-day value on carried interest, even when the profits won’t be realized for years to come. While a Black-Scholes model can create general estimates that will often work for rosier valuations, using a Discounted Cash Flow (“DCF”) model will generally produce more comprehensive results when a more comprehensive valuation is necessary.
Carried Interest & Actual Investment
When trying to determine the value of carried interest in a specific case using a DCF model, the first and most obvious consideration is the role of the starting capital in question. How much has been invested into the fund by the investor and how much capital will a fund need to earn to reach its current goals? Determining this requires some discussion with fund management as to what those capital goals are. Getting an idea of how the fund is using its capital is an important start to making an accurate assessment.
Determining an Expected Rate of Return
Fund management should have an answer in place to the question of the internal rate of return (IRR) depending on when the fund plans to divest. What is the timeline for getting that investment back, and what returns are expected to be produced for shareholders? Because carried interest is used for ongoing investment vehicles, knowing when the exit from an invested asset is expected to occur is an important step in gauging whether or not the investment justifies the expense.
Carried interest occasionally makes an appearance in the media, often in a political context. Financial experts sometimes debate whether carried interest should be taxed as income or capital gains. This and other external pressures on carried interest must be taken into account during valuation. Legislative pressures may only be relevant in cases where a change in the rate of taxation is proposed—and these proposals do come up fairly often—but they still require consideration. Other factors to discuss include whether the carried interest will be sustainable in the context of the fund’s projected earnings. Investigating external mitigating factors on carried interest helps determine its value in the context of the fund’s value as it stands today.
Is DCF Best For Valuation?
Depending on the purpose of a valuation, a simpler model may be used to get a general picture, but a DCF model will help gauge the real and future value of carried interest, as well as realistic assessment of a fund’s future direction. Which model will be a better fit for the task at hand will depend largely on the investments themselves, the size of the projected profits, and the knowledge of the valuation expert.