Carried interest valuation considerations
The timing of, and commercial drivers for, the carry being acquired or disposed of will often guide us in determining the appropriate valuation method to use. We have set out below an overview of the valuation methods which we use in practice, and explain when and why each is appropriate.
Is it always necessary to get a valuation?
Clients may ask whether it is always necessary to obtain a formal valuation, especially where the carry pot would appear to have a very low or even negligible value. Examples might be when the fund has not yet exited any investments, or where it is only part way towards achieving the hurdle. It may well be the case that the value is low. However HMRC will expect to see analysis in support of the value, and whether or not a formal valuation is appropriate will depend on the specifics in play.
One exception to this is that, when carry is acquired at the start of the life of the fund, it may well be covered by the MoU, which is a Memorandum of Understanding between the BVCA and Inland Revenue from 2003 relating to venture capital/private equity limited partnership funds. In effect, the MoU says that, provided specific conditions are met, the initial unrestricted market value (IUMV) of the carried interest will be the nominal amount actually paid for it, if it is acquired before the fund makes its first investment, or if the fund has started making investments but it can be shown that the aggregate value of the fund’s investments has not increased above the acquisition cost. This would need to be considered on a case-by-case basis, but if the MoU applies, a valuation of the carry will not usually be required.
There are three valuation methods which we use most often in practice.
1. Option pricing valuation methodology
An option pricing valuation methodology is typically applied when valuing carried interest in the very early life of the fund, but when the fund is not compliant with the MoU. Due to the fund being early stage, there is typically a lack of underlying forecasted cash flow data associated with the fund or its underlying investments, so this model uses wider market data to estimate the value of the carry.
There are a range of option pricing techniques, such as:
Black-Scholes Option Pricing Model, which is a continuous time mathematical model. Key inputs are the current value of the asset, exit period, expected volatility, risk free rate and exercise price.
Lattice Models, which are discrete time models such as the Binomial Option Pricing Model. Key inputs for this include the assumed expected return scenarios and the probability of achieving such returns.
Monte Carlo Simulations: this involves variables that are typically simulated under a risk-neutral framework including assets under management, NAV or IRR. Usually 10,000 to 50,000 simulations are run and the average of the outputs is used to estimate the market value of the carried interest.
In broad terms, these models reflect the ‘hope’ value of the carried interest, so inevitably means that where the inputs are based on wider market data this may in fact materially differ from the actual underlying data relating to a specific investment. For this reason, these valuation methods are usually not considered appropriate once reliable forward-looking valuation data becomes available.
2. Probability Weighted Expected Returns Approach (PWERM)
A forward-looking expected liquidation value approach is typically applied when the fund has begun making investments but has not yet realised many investments, and uncertainty remains around future performance. This will likely be in the early to mid stage of the fund’s life.
This valuation methodology is heavily dependent on the facts and circumstances as at the valuation date. It will reflect expectations of uncertain future performance based on the knowledge, expertise, and data derived from the fund’s current performance as at the valuation date.
In short, the PWERM approach works by analysing discounted cash flows for the carried interest in a range of possible future scenarios:
First, we estimate the future value of carried interest distributions to the fund. We typically consider three different performance scenarios for each investment (i.e. upside, base case and downside) and run the projected distributions in each scenario through a waterfall to derive a future value for the carried interest. Weighted average future values are then computed.
Second, we derive a present value by applying a discount rate that reflects the riskiness associated with the forecasted distributions to the weighted average future value of the carried interest.
Finally we apply a discount for lack of marketability to reflect the fact that the carried interest is not a publicly traded asset and is therefore illiquid and any holder assumes significant liquidity risk.
3. Current Liquidation Valuation Approach
The current liquidation approach is typically applied in scenarios where the carried interest is ‘in-the-money’ after the catch up has been operated, or when the fund is coming towards the end of its life cycle. In broad terms, this method of valuing the carried interest works by establishing the carry distributions which would be expected in a hypothetical situation where the fund is liquidated on the date the valuation is being carried out, based on the current value of the underlying investments.