Profit-sharing is a distinct feature of the alternative investment industry. Private equity, venture capital, private debt, and real-estate firms all utilize deferred compensation agreements between founders, partners, advisors, and select employees. These deferred incentives are typically structured as a portion of future profits (or carried interest) generated from performance or incentive fees charged to outside investors (or limited partners). As deferred incentives become a larger portion of total compensation, forecasting what these incentives might be worth in the future is important to recipients. In this blog let’s delve deeper into carried interest forecasting models. We’ll start with a scenario looking at how a hypothetical firm would forecast carried interest to employee recipients.
Next we’ll look at six different ways alternative investment firms structure their carried interest forecast models. Finally we’ll look at how employees approach deferred compensation forecasts and times when employees build their own models, and the uncertainty they can create.
The general rule of thumb across the buyout fund industry, for example, is to assume that successful investing will result in doubling the fund size of committed capital over the life of the fund – typically 10 to 12 years.
Consider the following scenario. A firm sets a future multiplier of 2X on a $1 billion fund. The fund assumes it will double its value returning $1 billion in profit and $1 billion in return on capital. If the firm receives a 20 percent incentive fee, then it will receive approximately $200 million from outside investors (not considering factors such as an 8 percent preferred return, GP catch-up, and other components of limited partnership agreements). Employees who have a 10 percent carry allocation walk away with $20 million.
That’s all fine on paper, but the forecasting model doesn’t necessarily reflect the reality of a fund’s growth. The fund may outperform or underperform. Employees and partners with awards in a given fund don’t know their actual compensation until it’s paid out when they finalize their distributions. This opacity is the reality at many firms. Why? The first reason is market conditions. The second is institutional inertia, or firms repeating carry agreement and compensation forecasting approaches from years prior and/or prior positions at other firms.
There is no shortage of ways we’ve seen firms structure their carried interest forecasting models. Below is a quick overview of different approaches:
When new awards are issued, firms correlate a dollar amount to the percentage of awards. For example, the fund may estimate that the new fund will eventually return $100 million to the carry award holders. If an employee has a 1 percent carry allocation in this fund, they are told their award is valued at $1 million (assuming the fund returns what they expect). Some firms limit their forecasting to this one-time projection, which is usually based on an initial multiplier. For some firms that use this method, the only reporting is often an award letter with this projection.
Firms apply a future multiplier to investments. The industry norm is 2X, but some might use lower or higher multiples, and some firms will have base case and stretch case multipliers so that participants can see various scenarios. This method allows firms to predict future returns and distributions based on what’s been committed to the fund. This method is easier to calculate than some other models, but isn’t always an accurate gauge of results, especially for more mature funds where the firm has a better sense of performance.
This method doesn’t provide future value but instead provides the value as if the fund liquidated all its investments as of the reporting date (i.e., GP carry participants’ portions of the unrealized waterfall multiplied by participants’ carry allocation portions). Firms will take the gross amount of unrealized carry on their spreadsheets, or systems such as FirmView will allocate pro-rata to the participants.
Some firms use a combination of approaches 2 and 3 above to account for what’s known and unknown. For example, they will take the unrealized gain/losses for investments that have been made, and apply a multiplier (e.g., 2X or another factor) for unfunded commitments. Together, this approach offers a picture of what an employee’s carry allocation is worth at any given point in time plus a future prediction. To take this method a step further, the firm can project future changes to the investments that have been made on top of the unrealized gain/loss.
Some firms compute their expected future value of carry based on their knowledge of their investments, strategies, and exit plans. They will determine the gross amount that they expect to return and allocate this expected amount down to each participant.
This plan is often used for real estate investors or other sectors, such as credit, where revenue streams are better known. Allocation is tied to expected cash flows over regular intervals. Firms can therefore present year-by-year estimates to plan participants. Generally, this method allows investors to better predict the timing and size of distributions.
Whatever method fund managers use, participants are usually not aware of their exact earnings until a fund’s life is completed. Though the six methods above help provide some level of forecasting, there’s no way for them to predict future earnings with 100 percent accuracy. However, providing employees and other carried interest agreement participants a robust forecast based on a combination of the six methodologies certainly helps.
Conversely for firms that conduct minimal forecasting or forecasting only at the commencement of a fund, participants cannot gauge future earnings unless they keep their own forecasting models. These participant models will almost certainly not include all of the variables that employers have access to. This opaqueness can increase retention risks. If employees cannot reliably assign a value to future awards, their openness to new opportunities may increase.
Overall, transparent comp and carry plans help employees see the long-term potential of their awards along with various other components and complexities of their long-term incentive packages. As a technology firm that focuses on carried interest reporting and forecasting participants’ carried interest, we are seeing this transparency enhance our clients’ communications with employees on carry allocations, vested/not vested splits, and future compensation.
FirmView® is comprehensive carry and compensation software solution to manage allocations, joiners, leavers, vesting, forecasting and reporting with a dedicated employee portal. FirmView® Carry and Compensation (formerly PFA Solutions) also includes management of co-invest obligations, and full compensation including, salaries, bonuses, and retirement, to provide enhanced management and employee reporting.
Reach out to the Allvue team to learn how you can leave spreadsheets behind.