Carried Interest Appraisals: A Guide to Valuation Methods & Allocations

What Is Carried Interest?

Understanding the role of carried interest in private equity, real estate, and hedge funds.

Carried interest (or “carry”) is a way of rewarding professional investment managers with a share of an investment’s anticipated profits. The real estate industry refers to carried interest as a “promote;” for alternative asset funds such as private equity, real estate, private credit, and hedge funds, this performance-based incentive grants fund investment managers or general partners (GPs) a share in the partnership’s capital appreciation. However your fund is structured, the importance of proper valuation and allocation cannot be overstated, as an improperly done appraisal can cause you millions in unanticipated tax liabilities.

Read on for answers to your questions about waterfall allocations, vertical slice, derivative agreements, DCF vs. Monte Carlo methods, and how to identify common IRS pain points.

Waterfall Allocations: How Carried Interest Is Distributed

Key return thresholds and payout structures that impact valuation.

Payouts to fund managers usually depend on achieving certain return thresholds, thus requiring a “waterfall” distribution of allocations across different investor return breakpoints. Depending on your fund’s economic structure, carried interest can be paid out annually based on calendar-year performance, as is common with hedge funds; or in the case of private equity or venture capital, the carry may instead be paid years after the fund’s launch—after investments have been held for years and then sold at large multiples of invested capital. Either way, proper handling of the waterfall allocation is essential to create a defensible valuation and protect your assets.

The Vertical Slice Rule: IRS Compliance and Gifting Strategies

How fund managers can navigate IRS rules when transferring carried interest.

The “vertical slice” refers to an IRS rule (Section 2701) that typically requires fund managers to gift their pro rata ownership percentage of the GP capital contribution relative to their gifted pro rata ownership of the carry.

For example, say you own 10% of the GP capital contribution and 50% of the carry; to gift a 50% vertical slice of your GP interest, you would gift 50% of both your pro rata interest in the fund’s carry (i.e., 25% of the fund’s total carry) and your pro rata share of the GP capital contribution (your 10% ownership multiplied by 50%). The GP capital contribution, which likely comprises either a cash contribution or management fee waivers, is generally valued independently of the carry because it possesses materially different economic characteristics. Many appraisers value components of the vertical slice using an income approach; while others utilize Monte Carlo analyses in their valuation—both methods are discussed in greater detail below.

Carried Interest Derivative Agreements: A Tax Planning Tool

How derivative agreements help fund managers transfer carried interest efficiently.

Often, instead of gifting the capital contribution component of the GP interest, individual fund managers prefer to execute a derivative agreement between themselves and a trust for their beneficiaries. Typically, the individual employed by the fund manager or fund GP may fund the subject trust with sufficient cash and then will sell to that trust, a derivative agreement, which entitles the trust to the economic rights of the carry upon achieving certain criteria, known as a “hurdle”.

For example, after the GP receives $1.0 million in carry distributions (i.e., the hurdle), the remainder of the carry will be paid by the individual to the trust on the agreed settlement date—say, the eighth or tenth anniversary of the derivative agreement. An appraisal is often required to assess the fair market value of any unpaid or accrued carried interest that remains undistributed as of the settlement date. Furthermore, the agreement may stipulate multiple settlement dates for paying out historical carry, often referred to as “interim payment dates.”

Adequately valuing a carried interest derivative entails additional layers of complexity compared with valuing a vertical slice, so appraisers often utilize a Monte Carlo or option pricing model. When using the latter, the appraiser generally must value the carry as a whole and then use that as the theoretical stock price so the hurdle reflects the strike price of the theoretical option.

DCF vs. Monte Carlo: Choosing the Right Valuation Method

Comparing discounted cash flow and Monte Carlo simulations for carried interest appraisal.

 The actual carry of the fund is most commonly valued through a single DCF analysis, a multiple-scenario DCF analysis, or a Monte Carlo which will simulate the cash flow of your fund, allocating potential cash flows across the fund’s different distribution classes in each year, and then present-value each year’s cash flows back to the valuation date. This grows more complicated as the fund’s waterfall incorporates additional return thresholds for increased carry percentages; furthermore, determining whether the fund pays carry on a deal-by-deal basis or on a fund-return basis can drastically change the allocations and thus impact the valuation. Hedge funds present a particular challenge, as the forecast must account for investors to exiting the fund over time, which impacts the capital accounts attributable to the investor classes and carried interests receivable.

The Monte Carlo method has increased in popularity among appraisers more recently, largely stemming from the increased flexibility. After putting the forecasted fund cash flows on a risk-neutral basis, you would then use a random number generator to simulate returns based on the geometric Brownian motion. Next, you would allocate the returns in each year down to the ownership interest (i.e., limited partner vs. general partner/sponsor)—according to the limited partnership agreement (“LPA”)—and then discount the risk-adjusted GP cash flows back to the valuation date.

IRS Pain Points: Common Mistakes in Carried Interest Valuation

Avoiding IRS red flags, improper discount rates, and incorrect waterfall allocations.

Gifts of economic interests in GP carried interests are often financially substantial in nature, potentially encompassing millions of dollars in value, making them especially attractive targets for the IRS. The discount rate and discount for lack of marketability (“DLOM”) often fall under the highest level of IRS scrutiny. Correct selection of an appropriate discount rate to determine the net present value of the forecasted carried interest often relies on historical fund performance and historical asset class benchmark returns. Using a put option model to estimate a DLOM often raises IRS attention due to the challenge of making a volatility selection. Restricted stock studies are often quite risky, too, unless there’s data that allows you to compare the gifted interest to a similar interest in a similar company. Other common pitfalls include incorrect allocation of cash flows according to the LPA, using a European fund model instead of a deal-by-deal model, and incorrectly modeling the derivative.

Why a Defensible Carried Interest Appraisal Matters

How the right valuation approach protects against costly tax liabilities.

That’s why a defensible appraisal is essential to protect you from an unexpected liability. Carried interest can be an exciting way to be rewarded for successful firm performance, however choosing the wrong appraiser can result in large and unintended tax liabilities. Selecting the right appraiser is critical for your ability to achieve tax compliance, given the size of these types of gifts—not to mention the increasingly aggressive IRS audit environment.

Ensure Your Carried Interest Valuation Stands Up to Scrutiny

Carried interest can be a powerful incentive, but improper valuation can lead to significant tax liabilities and IRS scrutiny. A defensible appraisal requires deep expertise in waterfall allocations, valuation methodologies, and regulatory compliance.

Need a trusted valuation partner? Our experienced team specializes in carried interest appraisals, ensuring accuracy and tax efficiency. Contact us today to protect your assets and stay compliant.