Carried interest, or carry, is a share of the profits of a successful partnership paid to the manager (general partner) of a private equity or hedge fund. Carried interests are management incentive compensation to maximize performance. Carried interest allocations are in addition to investments the manager may have in the fund. As such, carried interest recipients do not pay anything for them. Also note that carried interests exempt their owners from participating in losses (or capital calls).
To benefit from a carried interest, the manager must first return all capital contributed by the investors (limited partners). In some cases the fund must also return a previously agreed upon rate of return (the hurdle rate) to investors. In others, the fund must also return all management fees. In other words, the carried interest does not kick in until (1) limited partners have received all of their investment plus possibly (2) a hurdle return and / or (3) management fees. The fund agreement details which of these conditions are relevant so that you can model carried interest returns.
In private equity, the standard carried interest allocation historically has been 20% for funds making buyout and venture investments. Carried interest rates among hedge funds have historically also centered around 20%, but have had greater variability than private equity funds, occasionally reaching as high as 50% of a fund’s profits. Most carried interest hurdle rates I have seen center around 8%. Most management fees I have seen average 1 to 2% of committed capital (funds already invested or earmarked for pending deals).
Carried interests are call options on the value of the limited partners’ assets in excess of invested capital and possibly the hurdle return and / or management fees. They can be valued using the Black-Scholes Option Pricing Model or perhaps a lattice model. If you Black-Scholes, many free online calculators are available (Google them), or build it yourself in an Excel spreadsheet. (This takes a few minutes, but it is well worth it. As you will see below, you will often run multiple value calculations, and having your own spreadsheet will be quicker than reentering data into an online calculator.) Use the following assumptions (and sources):
1. Value of the subject assets on the valuation date (from the manager).
2. Years to maturity (from the manager) is the expected life of the partnership pool, historically five to seven years, but now as long as ten because of the decline in the stock market. I run calculations for maturities of 5, 6, 7, 8, 9 and 10 years. (This is why I built my own Black-Scholes model: I can do this automatically.)
3. Risk-free (Treasury bond) rates for the relevant maturities (many online sources).
4. Strike price, the value of invested capital on the maturity date(s), plus (if applicable) hurdle returns (these are usually computed using simple, not compound interest), plus management fees (if applicable). Note that the value of invested capital should be increased by any known / committed new investments as of the valuation date. I do not increase invested capital for unknown investments, as that would be speculative, particularly in this down market where deals are scarce. (All of this should be supplied by the manager).
5. Volatility (many online sources) can be a broad market index such as the CBOE NASDAQ volatility index (VXN) or something more specific, if the fund is invested in identifiable industry sectors and such volatility indices are available. If you use the VXN, current (short-term) volatility is over 0.41 (41%) as a result of the market decline. Longer term it has averaged about 0.25 (25%). I believe that this lower value is appropriate for a multi-year investment fund horizon. This is the rub with option models: the higher the volatility, the higher the option value, because there is an increasing chance of the portfolio value exceeding the current value, but we have relatively wide latitude in choosing the volatility index and time frame.
The model values a call option on 100% of the profits above the current value of the portfolio; i.e. a 100% carried interest. Multiply that by the carried interest percentage to get the value of the subject carried interest.
I do not believe that a lack of control discount applies to carried interests because they are awarded to the general partner, who controls all aspects of the fund. Lack of marketability discounts may apply if there are transfer restrictions or other liquidity constraints. Read the fund agreement and value this just as you would a non-marketable minority interest in a private business or partnership.
Now, carry on!