The gifting of a carried interest presents a unique opportunity for private equity fund managers, as it can allow for a substantial transfer of potential value while minimizing the tax impact. Why? Given the expectations of a fund’s long-term holding period, which includes a transition from incremental to exponential growth stages, fund managers’ carried interests are often valued for gift tax purposes at a small percentage of their future potential cash payout. Thus, the timing of the gift transactions relative to the life cycle of the fund is a critically important factor to consider in structuring a gift and estate tax planning strategy to its fullest tax savings potential.
Carried Interest and How It Is Valued
To further explain this point, an understanding of how the valuation of a carried interest works is helpful. As compensation for managing a private equity fund, managers of such funds are generally compensated and incentivized in two ways: management fees and carried interest. Fund managers receive management fees, which are usually based on either committed capital or remaining invested assets, depending on how far along the fund is in its life cycle. In addition, fund managers receive carried interest, which is essentially a share of the fund’s profits after investors have received their original contribution along with an agreed-upon preferred return on their investment.
For valuation purposes, carried interest is treated as an expected future cash flow to the holder of the carried interest. This expected future cash flow is valued using a discounted cash flow model that estimates the value of the future cash payment today by applying a discount rate and “discounting” that expected future cash flow to the present. This model has two basic inputs: the number of periods to discount (e.g., the number of years before the carried interest is expected to be paid) and the discount rate, which measures the risks and uncertainty inherent in holding the carried interest and realizing the expected benefits sometime in the future.
Why Timing Matters – The Simple Math
The nature of the discounted cash flow model dictates that, if all other factors are held equal, the longer it takes to realize an expected cash flow, the less valuable that cash flow becomes. This is purely a function of the mechanics of the discounted cash flow model.
To illustrate this concept, Figure 1 shows the present value of a $100 dollar future cash flow assuming hold periods ranging from one to ten years. As illustrated in this chart, the further into the future that a cash flow gets, the less value it has today. This point alone makes a compelling case for gifting carried interest as soon as possible so that the potential carried interest cash flow will be discounted over the maximum number of periods.
Figure 1
Why Timing Matters – How the Risk of Carried Interest Changes over Time
Timing also plays a significant role in assessing the magnitude of risk inherent to a carried interest which, in turn, affects the extent of an applicable discount rate used to value the carried interest. In considering this point, keep in mind that the risk of any projected cash flow is intrinsically tied to the level of uncertainty related to that projected cash flow in terms of timing, extent, and execution.
The lifecycle of private equity funds consists of three basic periods: Capital Raising, the Investment Period, and the Harvesting Period. Each of these segments bears its own set of risks, and all of these individual risks contribute to the overall risk profile of the carried interest.
The change in the total risk of a carried interest over time is illustrated in Figure 2.
Figure 2
During the Capital Raising Period, fund managers attempt to secure the fund’s capital base that will be used to make investments. The important point here is that, until the fund closes, the amount of capital that the fund will have to invest is uncertain. This directly affects the potential for a carried interest payout because potential profits are determined, in part, by how much capital is invested. While there are certain factors that may mitigate this risk (e.g., a track record of fully or over-subscribed funds), until investors have actually made their capital commitments, the capital base of the fund and the potential for a carried interest is uncertain. This introduces more risk into the carried interest, justifying a higher discount rate, and can result in a lower fair market value for gifting purposes (all other factors held equal).
During the Investment Period, funds attempt to deploy their committed capital by making investments. In order to produce a significant carried interest for its managers, funds have to deploy their capital so that it can earn a return desired by investors. Additionally, managers run the risk of overpaying for assets and weakening returns. In the past, it could be said that there were more deals than investors, but this has certainly changed. The amount of competition for investable middle-market companies with strong management and sizable growth potential is increasing. Fund managers are seeing less quality deals in their pipelines and are often battling with escalating valuations due to larger pools of bidders for the same assets. This means the total risk associated with the carried interest is high when there is still considerable uncertainty associated with the fund’s investments and declines as the fund begins to assemble its portfolio. As was the case with capital raising risk, greater risk justifies a higher discount rate, which can result in a lower fair market value for gifting purposes (all other factors held equal).
Once the capital has been raised and investments made, the primary determinant of the timing and amount of carried interest received by the managers is the profit made on investment exits. During the Harvesting Period, funds look to exit their investments either through initial public offerings (IPOs) or by selling the underlying businesses. The primary uncertainty in this period is whether funds will be able to exit their portfolio holdings at a premium to their original investment. Progression through the Harvesting Period has the opportunity to lower the uncertainty of the carried interest exponentially for a number of reasons. First, as exits occur, the fund may meet its hurdle requirements to limited partners after returning contributed capital and a preferred return. Additionally, as a fund nears the end of its hold periods on investments, managers generally have a much better idea on where the fund will be able to exit, given an investment’s performance. This allows the projection of a fund’s total profits and the carried interest with much more accuracy relative to the early stages of a fund. This diminished uncertainty supports the use of a lower discount rate, which (all other factors held equal) can result in a higher fair market value for gifting purposes.
What Does CohnReznick Think?
If transferring a carried interest is part of a gift and estate tax planning strategy, it is best to transfer value during the early stages of a fund’s life cycle. Such stages maintain the greatest amount of uncertainty regarding the eventual payout to a carried interest, which often results in a lower valuation, due to the time to liquidity and the considerable risks inherent in the carried interest.
Contact
For information on the income tax implications of gifting carried interest, contact Ira Herman, CPA, CEA, a CohnReznick partner and Trust and Estates Practice Leader, at 973-618-6245 or [email protected] or visit CohnReznick’s Trust and Estates Practice webpage.
To learn more about the valuation of carried interest and management fee streams for a variety of fund types (e.g., general buyout funds, venture funds, growth funds, opportunistic funds), contact Daniel Hogancamp, a manager in Valuation Advisory Services, at (732) 635-3207 or [email protected] or visit CohnReznick’s Valuation Advisory Practice webpage.
