Valuation of General Partnership Interests in Private Equity Funds

INTRODUCTION

Partnership Interests in a private equity structure are typically represented by an obligation to contribute a certain capital amount and a right to receive proceeds from the realization of portfolio investments. Because of the specifics of private equity compensation structure, general partnership (GP) interests’ value extends beyond the contributed capital, even in the beginning of the fund’s life, when little to no capital has been deployed.

In many private equity arrangements, the GP may be entitled to compensation above their portion of returns on invested capital, if certain return thresholds are met for the limited partners. This additional compensation is often referred to as carried interest and it has value to its holder even if parameters that may entitle the GP to carried interest have not yet been met. Due to these characteristics, it is often more difficult to assign a value to such interest as compared to a typical operating or holding company’s ownership interest. However, just like in the case of an operating company, such an interest is also represented by a stream of cash flows, which, providing that certain considerations were accounted for, is possible to reliably estimate over a given period of time. The value of a private equity interest is represented by a multitude of variable factors such as the size of the capital commitment, a certain investment decision or a series of decisions, the expected time period to the realization of the investment proceeds, and the structure of the distribution proceeds agreed upon by the GP and limited partners (LPs), along with many other decisions and factors, and last, but not the least, the risk surrounding the future cash flows.

At certain times and circumstances, it may be desirable or necessary for a GP interest owner to transfer their interests for estate planning or other purposes. Thus, the questions arise – how do we value such interests, how does the value change depending on estimated holding period, what is the process like, and what factors impact the value. The goal of this article is to familiarize the reader with the nature of GP interests as well as provide an overview of basic concepts related to their valuation. The timing and other specifics affecting the value of a GP interest will be discussed in following articles.

OVERVIEW OF COMPONENTS OF A GP INTEREST

In a typical private equity fund, general partners’ capital commitment usually ranges between 0.5% and 5% of the total capital commitment of the fund. General partners invest their capital alongside limited partners and are entitled to a return of their capital plus compensation, known as carried interest. Further, GP also collect management fees during the life of the fund, usually regardless of the fund’s performance, which allows GP to support the fund’s operations.

In a private equity structure, the fund manager and general partner are two separate entities, but they are typically related. The management entity’s job is to run day-to-day operations of the fund, and it gets compensated by management fees throughout the fund’s life. The management entity does not participate in a carried interest. In some structures, management fees are designed to only cover operating expenses, such as staff salaries and legal and administrative expenses, but in instances where there’s management fee surplus, this income is distributed to general partners and treated as ordinary income for tax reporting purposes. The GP’s reward for providing significant value to the fund, is the carried interest, which is distributed to the general partners upon the fund meeting certain requirements for return of capital and profits to limited partners.

OVERVIEW OF CARRIED INTEREST

What is it?
Carried Interest is a form of compensation attributable to general partners in certain Private Equity, Hedge Fund or Real Estate Investment structures, paid upon the fund meeting predetermined return requirements for the LP’s.

What is the difference between compensation of General Partners and Limited Partners?
Limited Partners supply most of the capital to the fund, but they do not contribute any time to the management of the fund. In order to incentivize them to invest their money into the fund and have it locked up for a specific period of time, they have to be promised a return of their capital, dollar for dollar, plus a certain return on their investment, before they agree to allow the fund manager (GP entity) to get any residual compensation (i.e., carried interest).
The general partner entity is the “Brain” and Management of the fund. It raises the capital, chooses the investment strategy, investment management personnel, finds the investments, adds value to investments, and sells the investments during the life of the fund.
Therefore, it gets compensated by carried interest only after meeting predetermined criteria for the fund’s realized return.

How is carried interest calculated?
Upon initiating a fund, all partners (general and limited) agree on all the terms of the fund, including its waterfall distribution structure, which specifies how the returns will be distributed to all partners.
Waterfall distribution structures vary, depending on type of the fund and agreement between partners. Typically, after returning all invested capital back to limited partners and paying the agreed upon hurdle rate of return, general partners get a portion of residual profits received by the fund, which constitutes the carried interest.

How’s carried interest valued?
Simply put, carried interest is a projected stream of future cash flows to general partner. Therefore, after we allocate all projected returns to all limited and general partners according to the fund’s waterfall distribution structure and determine the applicable discount rates for the return of capital and the carried interest portions of the fund’s proceeds, we account for the effects of tax and then discount projected after-tax cash flows back to present by the applicable discount rates, sum these cash flows, and arrive at the interest’s value.

SUMMARY

Along with return of capital, carried interest is a stream of income to the general partner over a specified period of time. It has a known time horizon (determined by the term of the fund and timing of projected distributions), payment structure (determined by the waterfall distribution clause), and the risk surrounding the future cash flows. The present value of these future cash flows constitutes the value of general partner’s interest in the fund. As with any other operating cash flows over any period in the future, discounted cash flow method is the most reliable method to calculate the value of the return of capital and carried interest proceeds attributable to the general partner.