Investment managers are generally compensated based on the overall performance of a particular fund or series of funds under their management. Higher compensation rates for managers who meet or exceed expected returns have created an increasingly competitive career field among investment professionals.

What Is a Carried Interest?

Incentive compensation for fund managers often comes, at least in part, in the form of a performance fee known as carried interest. If a fund (typically a private equity fund) is able to perform at or above a preset rate of return, investors with a carried interest are entitled to a portion of the profits. Specific provisions involving timing, tiered return thresholds, and potential giveback of prior carried interest (“clawback”) often apply.

Challenges with Transferring Carried Interests

Private equity fund managers and other members entitled to a carried interest payment may find it somewhat difficult to include carried interests in their estate planning documents. Although there is no guarantee of carried interest performance, the value of the carried interest is expected to grow exponentially in value over time. The anticipated long-term growth means it is more advantageous from a tax perspective to transfer these assets to a family member or trust sooner rather than later. Carried interest gift allotments may fall below the allowable annual gift guidelines when the fund is new or fairly new; however, as the fund matures, the value of the carried interest may skyrocket and will become more expensive to gift. 

Carried interests often have time-based vesting provisions, and IRS regulations specify that a gift of an option-like interest such as carried interest is not complete until it has vested.  This means the carried interest will likely have increased in value by the time it vests, frustrating estate planning goals. Further, the IRS may require that a “vertical slice” of the fund be transferred for the gift to be effective, which is often not desired (a vertical slice being the carried interest plus a proportionate share of the invested capital). These issues may be avoided by using a derivative.

What Are Carry Derivatives & How Do They Help Solve the Estate Planning Issue?

A more advanced technique for transferring carried interest is the use of a derivative on the carried interest itself.  Such carry derivatives may help alleviate certain estate planning issues. When selling an option, or carry derivative, the owner utilizes an irrevocable trust account to create a cash settlement for the derivative, which is taxable to the owner of the trust in the present. The contract amount determines how much will be paid into the fund at a future date to represent the fair market value on the return of the carry. Owners may stipulate a floor, or hurdle return rate that must be met or exceeded before funds are due to the trust account.

This workaround had the potential to reduce or eliminate the tax burden on carried interest and may also bypass the generation skipping tax implications of the trust. Our team at Appraisal Economics provides advice and valuation in the area of carried interests and carried interest derivatives, and are happy to assist by answering questions and conducting a performance analysis.