The Starting Five A Winning Strategy with Carried Interests and Alternative Assets
The Starting Five A Winning Strategy with Carried Interests and Alternative Assets
Alternative asset portfolio managers and their wealth planners should factor in these considerations to drafting a winning estate plan.
This past summer, with an influx of revenue from broadcasting agreements, NBA teams positioned themselves for success in the upcoming season by spending tens of millions of dollars in the free agency market to improve their starting five rotations. In a similar fashion, amid the dynamics of the alternative asset industry, fund managers are also realizing material wealth and need to consider a number of options to ensure success in their wealth planning strategies. As a starting point, we present five initial considerations by asset class that fund managers and their wealth planners should address in drafting a winning estate plan.
To understand the importance for such planning, consider the current investing environment. Institutional investors and high net worth individuals are facing significant challenges in identifying opportunities for attractive yields and continue to allocate capital to alternative asset management firms. These investors and individuals seek the higher returns and reduced volatility afforded by diversified portfolios, which target lower correlation with the broader equity markets. At the same time, exchange traded funds and mutual funds, as well as rules recently implemented by the Securities and Exchange Commission under Title III of the Jumpstart Our Business Startups (JOBS) Act, have increased retail access to alternative asset classes and strategies.
As the pool of potential investors continues to expand, and as alternative assets become a mainstream component of the asset allocation process, fund managers and principals have increased opportunity to generate significant value from the fees and profits realized on higher levels of assets under management (AUM). The resulting value creation affords fund managers and principals, working with their estate representatives, multiple options for pursuing an efficient transfer of wealth to the next generation.
As a general introduction, it is necessary to understand the typical structure for alternative asset management firms, such as private equity firms and hedge funds. First, a fund sponsor raises an investment fund, or pool of capital, to be invested in accordance with one or more specific investment strategies. Each fund consists of capital sourced from third-party investors and the firm principals themselves. Second, the fund is typically run by a management company in exchange for an annual fee based on total AUM (generally 1.5%-2.0%), which is intended to cover salaries, legal expenses, and administrative costs. Finally, a separate general partner often realizes a performance fee, or carried interest, based on a percentage of the gross returns realized by the fund (generally 15.0%-20.0%), subject to a hurdle return or high water mark.
Within this structure, fund managers and principals derive value from three separate interests: 1) the general partner/carried interest, 2) the management company, and 3) a limited partnership interest.
The Starting Five
We present a starting lineup of five unique valuation implications and challenges that should be considered in developing a winning strategy centered on each of the above types of fund interests. Additionally, we also present a discussion of other alternative assets that may form the core of a successful plan, namely options and derivatives. We note that just as certain teams perform well within different styles, arenas, and situations, the applicability of each wealth planning strategy should be tailored to the circumstances of any particular individual.
General partner/carried interest
1. Methodology – The valuation and analysis of a carried interest in a private investment vehicle is complex, particularly because carried interests tend to have asymmetric payoff functions subject to hurdles, “catch up” distributions, and potential recapture. In valuing any asset class, it is important to consider the potential for such an asset to produce cash flow in the future. In the case of a carried interest, however, the interest’s “option like” payoff characteristics must also be considered, because the carried interest will have value only when the underlying assets achieve certain predetermined return thresholds. As a result, flexible option pricing techniques, such as Monte Carlo simulation, are often necessary to value these interests appropriately. Under this application, the Monte Carlo simulation is a cash flow-based analysis that enables the analyst to sample the distribution of potential returns for the underlying assets of a private investment vehicle (e.g., private equity or venture capital investment, pool of public equity or fixed income instruments) to generate thousands of potential outcomes for the value of the carried interest. Ultimately, the value of such an interest relates to the average of potential outcomes.
2. Volatility and correlation – In the context of a Monte Carlo simulation of the value of a carried interest, the volatility of the underlying assets of the private investment vehicle determines the range of potential outcomes of investment performance for a pool of assets. Similar to the value of a publicly traded call option, the value of a carried interest generally increases with higher volatility when using option pricing techniques such as Monte Carlo simulation. The correlation of the underlying assets of a private investment vehicle represents another critical assumption: higher correlation leads to a greater overall concentration of risk and a higher level of volatility for the vehicle as a whole. If a fund invests in publicly traded instruments, volatility and correlation are readily observable; however, if a fund invests primarily in illiquid assets, conclusions can be drawn by analyzing the publicly available historical returns of similar asset classes.
3. Employee compensation – When valuing an equity interest in the general partner of a private investment vehicle, it is necessary to consider whether non-equity employees maintain a claim on any portion of the carried interest and, if so, the extent to which they need to be compensated out of the carried interest in order to be retained. For example, a general partner owned by a small group of founders may grant notional amounts of the carried interest or promise employees performance bonuses that will be paid out from carried interest proceeds prior to distributions to equity owners. In valuing an owner’s ultimate claim on carried interest (and in valuing alternative asset managers generally), significant amounts of time and attention are spent developing diligent and accurate assumptions with respect to future employee compensation.
4. Capital allocated to investments – In the case of private equity and venture capital funds, a material portion of committed capital is used for various fees and expenses, including management fees, fund expenses, and organizational and syndication expenses. All else equal, funds with a higher portion of committed capital allocated to expenses exhibit a lower expected value for the carried interest because less capital is ultimately deployed into investments; however, hurdles for carried interest payments are based on gross capital contributions, including both fees and investments. In analyzing the value of a carried interest, assumptions with respect to the split between expenses and capital deployed into investments represent a key focus and value driver for the carry.
5. Waterfall provisions – Carried interests, though characterized somewhat generally in this article, can take on many forms. Any analysis of a carried interest should account for the specific terms and provisions of the private investment vehicle’s operating or partnership agreement, which tend to vary by asset class. For instance, open-ended hedge funds typically pay 15%-20% of all “new” profits in any year, meaning that investors’ historical losses, if any, must be recouped prior to payment of any carry. Private equity and venture capital funds tend to have relatively homogeneous structures, with 15%-20% of profits paid in the form of carried interest only after limited partners achieve a preferred return — usually around 8%, though this too depends on the asset class. Single-asset special purpose vehicles, which are common in real estate, may have different or complicated structures that feature multiple levels of potential payout at varying internal rates of return.
1. Methodology – Similar to a traditional fee-based investment advisor, the management company’s operations generate an AUM-based management fee intended to cover salaries, legal expenses, and other administrative costs. Thus, the most appropriate valuation methodology for management companies involves consideration of the traditional valuation approaches for an operating company, including both an income approach and a market approach. Both approaches emphasize an entity’s future earnings potential, use market data in the derivation of a value estimate, and are forward-looking in nature. Specifically, the income approach uses a market-derived discount rate to capitalize anticipated performance, while the market approach uses pricing multiples based on the market’s assessment of future performance. In applying these valuation approaches, several considerations, including those outlined below, must be thoroughly addressed to ensure that the analysis fully incorporates the management company’s risk and avoids overvaluing the interests therein.
2. Management fee – The timing and the magnitude of management fees depend directly on the amount of AUM. Management fees in certain private investment vehicles may be subject to additional adjustments for factors such as the length of the negotiated capital deployment window, offsets for additional fee-based income, and reductions for subsequent capital raised at new investment vehicles. Oftentimes, upon the initial establishment of the firm, when AUM is still low, management fees may simply allow the firm to break even on its expenses, thereby generating minimal value. As a firm matures and grows its AUM, however, the value of the stream of management fees increases due to the achievement of economies of scale.
3. Term – The application of an income approach typically involves a terminal period, which incorporates the assumption that a business concern has an indefinite life. In the case of certain private investment management firms (e.g., private equity, venture capital), this might not necessarily represent an accurate expectation. At a minimum, the investment funds that such firms manage have a finite life. Thus, to the extent that the valuation methodology incorporates an indefinite life for the private equity firm as a whole, the valuation analyst must make a projection of income premised on the expectation that new funds will be raised to replace the existing funds upon their terms’ expiration. In the case of an investment manager with an indefinite life, such as a hedge fund, empirical evidence of fund attrition rates should be considered.
The analyst must always consider the reasonableness of the assumption that new funds will be raised. This assumption is based on many factors, including the number of existing funds, the firm’s history of raising new funds, the past performance of existing funds, management’s expectation for new funds, and the firm’s ability to raise new capital. In many instances, it may be appropriate to incorporate a finite life for the private equity firm, particularly if the firm is smaller and has a limited history.
The legal structure governing the management fee can also impact the finite life assumption. For example, certain investment advisory agreements allow either party to terminate the agreement at any time. Additionally, many firms establish a separate investment manager for each new fund, thus limiting existing investment managers’ terms to the lives of their respective funds under management.
4. Discount rate – The selection of an appropriate discount rate in the application of an income approach is generally one of the more difficult valuation considerations, and is further complicated in the case of private equity firms in particular, given the nature of management fee income. First, the management fee is calculated as a percentage of committed capital over an initial investment period and is thus relatively stable. Thereafter, the management fee is based on actual invested capital and is therefore more difficult to project with the same degree of certainty. The additional risk and uncertainty in the projected cash flow stream must be considered in the selection of the discount rate.
Furthermore, the expectation for the term of a private equity firm is a consideration in determining the discount rate. In the event the analysis incorporates the expectation of new funds, the analysis inherently introduces additional risk regarding the ability of the firm to raise and deploy new capital successfully. This risk may be addressed through either the discount rate or the development of probability-weighted cash flows.
5. Market approach – The first step in employing the market approach is to research and identify potential guideline publicly traded companies. Because the valuation of the management company is considered separate from the carried interest, it is most appropriate to identify guideline companies with operations that generate the majority of their respective income principally from management fees rather than from incentive compensation. Examples of these types of companies include, but are certainly not limited to, AMG, EV, FII, BEN, GBL, IVZ, JNS, LM, TROW, and WDR. In analyzing the selected guideline companies, it is appropriate to calculate and consider several pricing multiples appropriate for this type of entity, including enterprise value/net sales, enterprise value/AUM, and equity/earnings before taxes.
Limited partnership interest
1. Methodology – Estate practitioners, in efforts to avoid triggering the arcane special valuation rules of Section 2701 of the Internal Revenue Code, often structure a gift as a “vertical slice” that incorporates the values of limited partnership interests into an estate plan based on their reported capital accounts, which are generally determined quarterly on a mark-to-market basis. However, estate practitioners also have the opportunity to apply a discount for lack of marketability. Private equity fund interests may warrant significant marketability discounts because they generally require extended lockup periods for investor capital in order to allow time for the fund to identify investment opportunities, deploy investor capital, and realize exit events. In contrast, hedge funds often invest in relatively liquid strategies that allow for the return of capital to investors on a more periodic basis, thus warranting lower marketability discounts.
In either instance, numerous empirical studies demonstrate the impact that lack of marketability has on the trading prices of securities in the marketplace. In particular, multiple studies analyze the price at which restricted stock was purchased in a private placement relative to the trading price of freely traded stock in the same issuer. In addition, other studies’ analyses of the private equity secondary market and listed private equity vehicles indicate marketability discounts based on a comparison of the market prices at which such securities transacted relative to their respective net asset values.
Finally, a quantitative approach is often applicable, particularly for hedge fund interests, through the use of a put option methodology. This methodology is premised on the notion that the cost of acquiring the put options to hedge against market exposure risk can be used as a proxy for an applicable marketability discount. In practice, it is important to use inputs for volatility, term, etc., that are comparable to the particular hedge fund interest under consideration, because there are no publicly traded put options on hedge fund interests.
2. Fund vintage – “Vintage” refers to the year in which a private equity fund is formed, and it may indicate the estimated remaining holding period of its investors: the later a fund begins to harvest its investments, the later the investors will receive meaningful distributions and, accordingly, the higher the discount. Along the same lines, the percentage of the overall capital commitment that has not yet been called by the fund provides an estimate of the remaining holding period: the longer it takes a fund to call and deploy its committed capital, the longer it will take to make significant distributions. Also, because investors in funds with significant remaining commitments are required to have cash available to be deployed as called by the fund, without knowledge of the manner in which it will be invested and how it will alter the ultimate composition of the funds’ investments, such funds subject investors to higher risk.
3. Withdrawal provisions – It is important to review in detail the operating or partnership agreement and other legal documents that govern a particular private equity firm’s or hedge fund’s operations. As noted above, investors in private equity vehicles often are subject to extended lockup periods, during which time they are not entitled to any return of or return on capital. Depending on its strategy and underlying portfolio, however, a hedge fund may provide opportunities for liquidity on a more periodic basis, such as quarterly or annually, thereby reducing the applicable discount for lack of marketability. Even with these types of funds, managers often have the discretion to enact “gates” that limit or eliminate withdrawal rights during certain times, as recently evidenced with the real estate funds following the Brexit vote.
4. Fund performance – The realized and unrealized returns for a fund are relevant indicators of a fund’s anticipated performance. That said, stronger-performing funds are generally more attractive to potential buyers. In addition to returns, the volatility of the underlying portfolio is an important benchmark for the risk that investors bear over the course of their respective holding periods until a liquidity event is ultimately realized.
5. Distribution history – Given the ability of a fund’s underlying portfolio to generate cash flow, the level of distributions a fund provides is an indicator of the liquidity an investor may be expected to realize on an ongoing basis. Furthermore, distributions may provide guidance regarding the remaining life of the fund and, by extension, the remaining holding period, because the ability to pay distributions is often based on the cash flow generated from the harvesting of mature investments.
Options and derivatives
Fund managers and principals, working with their estate practitioners, have an increasing number of available planning options to ensure the efficient transfer of wealth to the next generation.
1. Carried interest derivatives – Of the three types of interests that fund principals hold, the carried interest often is the one best-suited to achieve the most efficient transfer of wealth due to its potential for future appreciation. Recognizing a fund manager’s level of control over the fund’s operations, however, Section 2701 may require a transfer of the “senior” interest (limited partnership interest in the fund) in addition to the “junior” interest (carried interest). This so-called vertical slice results in a greater use of the lifetime exemption given the inclusion of the limited partnership capital interest in the transaction. At the same time, a transfer of the capital interest has a lower potential for appreciation and requires the transferee to fund future capital calls.
One planning strategy available to estate practitioners is the creation and transfer of a derivative instrument with a payout structure linked to the future value of a fund manager’s carried interest. As a simple example, a call option structure could be employed by structuring a payout only to the extent the underlying carried interest achieves cash flows above a certain threshold over a stated term. This derivative instrument achieves the objective of transferring the economic benefit of the carried interest while providing for flexibility in planning through the use of hurdle amounts, maximum payouts, or other desired economics. Furthermore, based on the terms and provisions of the derivative, the option price may likely reflect a material discount from the market value of the carried interest on its own.
2. Private options – The derivative approach may be extended to other types of assets for which it is preferable to transfer only an economic interest rather than the asset itself. These other types of assets could include 1) nontransferable assets subject to legal, regulatory, or other transfer constraints; 2) assets not expected to produce sufficient cash flow to cover note or annuity payments; 3) assets not anticipated to realize a return in excess of the Section 7520 rate; 4) unvested stock options; and 5) assets with significant built-in capital gains. Private options are structured as cash-settled call options that transfer only the increase in the value of an asset over the term of a contract, generally providing a payment to the transferee only if the value exceeds a stipulated strike price. Similar to the call option on a carried interest, the option premium may represent a material discount from the value of the underlying security, thereby providing significant potential upside relative to value transferred. As a result, private options are a unique way to achieve an efficient generational transfer of assets.
3. Option valuation methodology – In determining the option premium on carried interest derivatives or private options, it is necessary first to analyze the value and cash flow potential of the underlying carried interest or other asset. Such an analysis ensures that the option holder pays full and adequate consideration for the asset upon settlement. Following this analysis, the strike price of the option may be established at the determined fair market value of the asset or another stipulated price. To avoid Section 2703 issues, however, the strike price should not be set below the asset’s fair market value. Given these inputs, the valuation of a private option necessitates the use of option pricing techniques ranging from a closed-form solution (e.g., Black-Scholes Option Pricing Model) to more flexible techniques (e.g., Monte Carlo simulation, Binomial Option Pricing Model). For example, the value of a carried interest derivative may also be incorporated directly within a Monte Carlo simulation analysis used to value the carried interest itself.
4. Valuation discounts – In deriving the fair market value of an underlying security for inclusion within an option pricing model, discounts for lack of control and lack of marketability may be applicable depending on certain characteristics of the security. Numerous empirical studies and quantitative methods (the extent of which are beyond the scope of this article) are available to determine the magnitude of any applicable discounts. Any discounts applied reduce the asset’s value relative to the established strike price (assuming they are not set equal), thereby lowering the overall value of the private option.
5. Family entities – The creation of a family limited partnership or limited liability company funded with a percentage of the carried interest, management company interest, and limited partnership capital interest is another way to address the vertical slice issues Section 2701 raises. This strategy allows for the gift or transfer of limited partnership or membership units of the family entity rather than separate direct gifts of the various fund interests. It also allows for the application of valuation discounts traditionally applied to family entities of this nature.