In 1999, I began performing my first valuation of a carried and capital interest in a Private Equity Fund, which had a total capital commitment of $50 million. At that time, I was amazed at the size of the fund, thinking how large it was for a start up private equity fund. Now with almost 20 years under my belt since my first private equity valuation, I have had the opportunity to value several hundred of these interests in various types of funds - private equity funds, buy outs, hedge funds, and alternative investments, such as fund of funds with commitments ranging from a little as $25 million to as large as $5 billion and more.
Over the years, I have watched many of these funds evolve structurally and operationally over time to suit the changing climate of the investor needs and the industry’s competitive need to raise capital. This change came as a result of firm reputation, the economic and industry climate, competition for limited funds, as well as the crash of the sub prime market in 2007 that affected the ability of funds to raise capital, use leverage or finding good investment opportunities, among others.
As a result, pressure was placed on private equity managers/principals to evolve and to communicate with its outside investors with better financial disclosure, tighter fee structures, which ultimately affected investor returns -- net of fees and carry incentive.
While all these factors clearly affected the environment in which a private equity principal or manager operated in the private equity space, the valuation analysis of a carry and capital interest, as well as its drivers, remained fairly consistent.
When performing the valuation of a private equity manager’s carried and capital interest, you have to consider the importance of the future operating cash flows of the fund – its capital call and realization distribution curves. Often overlooked, this is perhaps one important aspect of valuing private equity, as these can vary from fund to fund and also vary from industry to industry. Understanding the private equity funds structure, its lifecycle, the investment period, the asset management/holding period, and its harvesting stage of the fund are all crucial to any valuation exercise.
Other important value drivers or factors include, but are not limited to:
The management fee, and how this fee is contractually paid to the managers or principals;
The expected waterfall or hurdle rate the principals of the fund are expected to satisfy before they are able to earn a single dollar of return for their hard work
The rate of returns that the principals typically expect from the type of investments that they make in the private equity fund,
All other expenses that are material and expected to be borne by the LPs are properly considered
All of the above factors are just some of the considerations when performing a carried interest analysis. Such factors can be found by reviewing several key documents, such as the Private Placement Memorandum, management’s investor presentation and regular updates, financial statements, as well as discussions with management. These are standard and generally expected to be considered by all appraisers when performing such a valuation.
Lastly, I was extremely fortunate to have performed all of these analyses of so many different funds over the years -- because, when seeking expertise, there is no substitute for experience. Values of private investments are exactly just that – private. There is limited publicly available information that discloses the expected returns of private equity firms, however, a detailed discussion with management, the principals and its outside investors often help to provide the relevant insight into the firm’s overall success and value itself.
Private Equity Carried Interest Valuation Considerations
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