By : Espen Robak | August, 12 2014Valuing Fund Carry – Consider the Market Evidence* Pure profits interests like a carried interest of a venture fund or hedge fund – at their inception – have zero intrinsic value.1 Much like out-of-the money stock options, they either make rapid leaps in value or expire worthless: this represents a significant transfer tax planning opportunity and gives rise to substantial valuation controversy every year. Due to the substantial growth in estate planning with carry – ongoing since at least the late 1990s – one would expect to have significant authoritative guidance by now on how to value such interests. However, little has been done in this area. To avoid the special valuation rules under Chapter 14, advisors often recommend transferring a proportionate share of all of the holder’s interests in the relevant entities (a vertical slice). In cases in which a vertical slice transfer is either impossible or undesirable, another kind of derivative interest can be transferred in the form of a private contract between the transferor and trust to pay the trust only the cash flows from the carry above a hurdle amount. During the last several years, we’ve seen the tentative beginning of a market in alternative asset manager interests.2 The purchases made by the investors in this market are of interests in fairly mature businesses with established managers and track records. These valuations, in other words, are likely not appropriate for start-up managers or funds that lack “institutional” features like a deep bench of investment professionals, a diversified group of investors and employment agreements and non-compete agreements locking in key employees. In addition, the interests purchased in this market include features of control and aren’t the kinds of interests typically transferred in intra family transactions.3 The valuation multiples derived from these deals typically represent the purchase price paid for a blended share of carry and management fees. The available information is mostly anecdotal, but multiples in a range around four to six times cash flow are often seen. Bifurcated further into compensation paid for management fees versus carried interests, multiple indications as low as in the two to three times range for carry could be reasonable. This, in turn, indicates discount rates in the 25 percent to 40 percent range.4 In addition, valuation discounts applicable to “contingent” and option-like securities are high.5 Finally, for many funds, there’s a strong argument in favor of the proposition that a significant portion of the management company’s and GP’s values represent the personal goodwill of the founding partner(s).6 Estate of Adell7 provides another, more recent, take. The court held that Ken Adell didn’t transfer his goodwill to his father’s company, STN, through a covenant not to compete. STN provided satellite uplink services for urban megachurches and Ken’s relationships with pastors were the business’ most valuable assets. And yet he was free to leave and use his relationships to compete directly against STN if he so wished. The values of those relationships weren’t an asset of STN, in the view of the court. Finally, in another recent case, the court held that Chester Bross personally owned the goodwill of Bross Trucking and ruled that the company didn’t transfer corporate goodwill to Chester in the relevant tax year.8 In both these cases, there was convincing post valuation date evidence supporting the idea that the companies in question had limited value without the key person. While carry transfers represent some of the best planning opportunities anywhere, the pitfalls are many. In particular, the valuation exercise is complex, resource-intensive and challenging. More than in most valuations, these are heavily document-driven, and the analyst should begin modeling with a “blank sheet of paper” rather than a preconceived model. The discount rates are very high, as are valuation discounts, but the empirical support is mostly derived from unpublished data or anecdotal sources. In addition, while there’s very little authoritative guidance available, any audit challenge could involve very substantial adjustments, due to the very large amounts transferred. Finally, given the personal and intangible nature of the business of most funds and the dependence on key professionals, a substantial portion of the earnings of the fund manager and GP could, in future controversies, be considered attributable to personal goodwill. * Excerpted, with permission, from an article in the upcoming issue of Trusts & Estates. Endnotes 1. Fair market value (FMV), which is the relevant value definition, is greater than the intrinsic value – however, the further out of the money an instrument is, the lower the FMV. 2. See, for example, Gregory Roth, “Dyal Capital, PE Fund Buying Hedge Firm Stakes, Tops Target”, Reuters PE Hub (Dec. 5, 2012). Also, Matthew Goldstein and Alexandra Stephenson, “For Sale: 20% Stake in Hedge Fund. Terms: Complicated.” New York Times (May 21, 2014). 3. In my firm’s experience reviewing deal docs for such investments, these transactions tend to give the minority investor the right to block many forms of decisions and, more crucially, the right to be redeemed in the case of certain adverse changes to the firm (including the departure of a certain key employees). 4. “A source told Buyouts in late 2011 that the fund aimed to achieve 25 percent returns, and that annual fees would make up nearly half of Dyal’s overall revenues.” Gregory Roth, Ibid. 5. See, Espen Robak, “Fair Value of Illiquid Securities – Are We There Yet?” Journal of Alternative Investments (Spring 2009), at p. 65. 6. Kerry Ryan, “Valuation Lessons From Estate of Adell”, Tax Notes (Sept. 22, 2014). 7. Adell v. Comm’r, TCM 2014-155. 8. Bross Trucking v. Comm’r, TCM 2014-107.