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CARRIED INTERESTS

The Mentor Group has performed numerous and significant valuations of carried interests in alternative asset management firms, namely hedge funds (HF) and private equity groups (PEG). These fund sponsors raise capital within defined investment pools, based upon clearly delineated investment strategies. Each fund includes monies from third-party investors and fund principals.

The fund management company, which usually includes some of the principals, receives a 1.5-2% management fee, covering administration costs, legal fees, and salaries. In addition, the general partner (GP) gets a performance fee or carried interest based on returns realized by the fund (usually 15-20%) after satisfying a minimum or hurdle return. Thus, fund managers and principals receive three sources of payouts: (1) GP carried interest, (2) management fees, and (3) limited partner interests.

The valuation of carried interests is often very complex, requiring assessments of how and when distributions are available and/or provided. Carried interest payoffs are usually subject to varying hurdles, which can be mathematically challenging to discern.

The starting point for the valuation is the underlying asset value(s). The ideal beginning is for each asset (e.g. portfolio company) to be stated at fair market value. Too often we are not asked to estimate this underlying value. Thus, our starting point is the investment capital or cost of each fund asset. Sometimes, management provides these current asset values and we use those in our analysis.

The carried interest is based on potential cash flows in the future. However, the carry is like an option, in that there is only value when certain predetermined markers are achieved from the underlying assets. Thus, based on the myriad of flexible option pricing within the fund, it is necessary to employ Monte Carlo simulation, or at least some type of scenario analysis. This enables the analyst to posit thousands of assumptions for the various asset classes and expected returns from each. Generally, the carried interest often increases with higher volatility of the underlying assets. The higher correlation to concentrated risk is reflected in more volatility and value in the carry.

Other factors which may affect a carried interest are the following:

  1. Non-equity employees may have a compensation claim on the carry.
  2. In general, higher amounts of committed capital for expenses will show up as a lower anticipated carry value. It is important to carefully distinguish between capital deployed into asset investments and that used for expenses.
  3. Waterfall attributes must be well-scrutinized in terms of the carry value. Simply put, the spray of water (waterfall) must be aligned by each investor class, asset, and IRR (internal rate of return) expectations. One example of an adjustment in the waterfall could be a provision to pay prior investor losses on some asset classes before any funds are earned or paid for the carried interest. The amount of "pref" or preferred return to investors before profits that is allocated to the principals is important. For many funds, this hurdle is 8%. However, there may exist many levels of potential payoffs at varying internal rates of return.
  4. The application of a discounted cash flow (DCF) approach involves a terminal value, which assumes an indefinite life. Private investment management firms have a finite life. Thus, the DCF should assume that new funds will be raised to replace existing funds. However, we analyze the reasonableness of this assumption (new capital replacement) based on fund attrition rates. For a smaller firm with limited history, a finite life assumption is probably appropriate.
  5. For a market approach (other than the individual values of portfolio assets), we consider public management companies. These guideline firms provide various ratio analytics, which in turn are used to estimate market multiples to apply to earnings (EBITDA) to estimate overall value. While this market approach is useful, it can be very challenging to accurately value carried interests using public company data.
  6. Based on the fair value of the underlying investments, another important calculation is whether there exists any carried interest already earned. We use a separate model for this exercise, versus the derived future carry.
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