Carried interest calculated on valuation is a share paid on a forecast.

The manager's share of a fund's gain, however the constitution names it, is a share of something, and the something is the whole question. In a well-drawn constitution it is realised value: proceeds received in cash, capital returned to the holders, the hurdle met on what they contributed, and the share calculated on what is left. In a badly drawn one it is net asset value: a valuation day produces a number, the number exceeds the hurdle, and the share is accrued and, in the worst versions, paid. A valuation is a forecast, a valuer's estimate of what an asset would fetch on assumptions the valuer states at a date the asset is not being sold, and a share paid on it is a share paid on an estimate. When the realisation comes in lower the share has already left the fund, been distributed to the individuals who earned it, taxed in their hands and spent, and the clawback that exists for that case is a claim against people for money years gone.

This note sets out what the share is a share of, the three places the constitution draws the line, why valuation is a forecast and what moves it, where the temptation to pay on valuation is strongest, the accrual that accounting requires and why it is not payment, the escrow and the clawback as the deal-by-deal cures, the continuation as a realisation that is also a valuation, the land platform's consent-driven valuations, the register's reading, a comparison, a worked calculation as a type, cases, what each party holds, the sequence, questions, terms and what to read.

What the share is a share of

The constitution defines the manager's share as a percentage of distributable gain after the return of capital and the hurdle, and everything turns on what "distributable gain" and "return of capital" mean. If they mean cash received by the fund from realisations and income, returned to holders and measured against the capital they contributed, the share is calculated on money that exists. If they mean the fund's net asset value less the capital contributed, the share is calculated on a number that exists on paper, and the constitution has to say whether it is also paid on it. The definition is two sentences and it decides whether the manager is paid for what it did or for what the valuer thinks it will do.

The three places the line is drawn

The basis. Realised proceeds only, with income counted or not as the policy says, and valuation used for nothing but reporting and the accounting accrual. The constitution says in terms that the share is calculated on distributions of realised value and on no other basis.

The timing. No payment of the share until capital and hurdle have been returned on a whole-fund basis, or on a deal-by-deal basis with an escrow and a clawback if the register accepts that. The constitution says when the share is paid and from what distribution.

The accrual. A share may be shown in the accounts as accrued on valuation, because the accounting standards require a fund to recognise the manager's contingent entitlement on its net assets, and the constitution says that accrual is an accounting entry and not a right to payment, so that the accounts and the waterfall agree about what has been earned and what has been paid.

Why valuation is a forecast

A valuation of a private asset is a valuer's estimate of the price a willing buyer would pay a willing seller at the date, on assumptions about the asset's future: a consent assumed granted, a programme assumed delivered, a rent assumed let, a comparable assumed comparable. Each assumption is a forecast, and the number is the product of the forecasts. A valuation moves when an assumption moves, which is why it can rise sharply on a consent and fall sharply on a delay, and why two valuers can produce two numbers from the same asset. A share paid on such a number is a share paid on the valuer's view of the future, and the future arrives at the realisation, which is the only number that is not a forecast.

Where the temptation is strongest

On a land platform, where valuations move sharply on a consent and the temptation to crystallise on the consent is strongest: a parcel worth one thing before its planning consent and twice that after is a parcel whose valuation day after the consent shows a gain the manager has not yet realised and may not, if the programme, the market or the exit fails.

On a continuation, where the transfer price to the new vehicle is a valuation the manager proposed and the share is calculated on it as if it were a realisation: the old fund's share crystallises on a number the manager set, for assets the manager keeps.

On a fund whose term is extended, where the manager's share on a valuation is used to justify the extension and the realisation that follows is lower.

On a fund with a deal-by-deal waterfall and an accrual the administrator treats as payable, where the accounting entry becomes a distribution by habit.

The accrual, read closely

The accounting standards require a fund to recognise the manager's contingent share as a liability or a deduction from net assets when it would be payable if the fund were liquidated at its net asset value on the date. The accrual is correct as accounting, because it tells the holders what the net asset value is after the manager's contingent entitlement. It is not payment, and it is not a right to payment, and the constitution says so: the accrued share is an estimate of what the manager would receive on a realisation at the valuation, reversed if the realisation is lower, and paid only on the realisation. An administrator that pays the accrual has paid a forecast, and a manager that treats the accrual as earned has booked a forecast as income.

Why constitutions end up paying on valuation

They end up there by three routes. A precedent drafted for an open-ended vehicle, where the manager's performance share is calculated on net asset value because holders leave on it, is adapted for a closed-ended fund without the basis being changed. An accounting accrual is written into the waterfall by a drafter who confused the accounts with the entitlement. Or a manager negotiating a land platform, knowing that the consents will move the valuation, asks for payment on the valuation day and a register that was reading the percentage agrees. In each case the basis was not read as the term it is, and the register's counsel that reads the basis first catches all three.

The hurdle on a valuation basis

A hurdle calculated on net asset value is also a forecast: the fund's net assets exceed the capital contributed plus the hurdle rate on a valuation day, so the hurdle is met on paper, and the manager's share begins on paper. On a realised basis the hurdle is met when the holders have actually received their capital and the hurdle rate on it in cash, which is later and is real. A constitution that tests the hurdle on valuation and pays on realisation is inconsistent with itself; one that tests and pays on realisation is the one the register wants.

The land platform's charges and the basis

A land platform's realised value is the sale price less the charges the sale bears: the Kingdom's transaction tax and additional charge on a non-Saudi owner's disposition, the registration charges elsewhere, the developer's promote beneath the platform, the lender's repayment. The manager's share is calculated on what reaches the platform after all of those, and a constitution that calculates on gross sale proceeds has calculated the share on the State's charge and the developer's promote as if they were the platform's gain. The valuer's instruction on a Saudi parcel deducts the disposition charge; the waterfall deducts it again in terms; and the accrual in the accounts is on the net.

Where it surfaces

At the first valuation day after a consent, when the accrual doubles and the administrator asks whether to pay it.

At the continuation, when the old fund's share crystallises on the transfer price the manager proposed.

At the extension, when the manager's accrued share is the argument for holding and the realisation is the rebuttal.

At the final realisations, when the clawback is computed against individuals who have left.

At the register's diligence on the successor fund, which reads the predecessor's basis before its rate.

The cost of getting it wrong

A share paid on a valuation that the realisation does not meet costs the register the difference, recoverable only by a clawback against individuals and only in part. It costs the manager a claim from its own holders and a reputation with the successor's register. It costs the fund's accounts a restatement and the lender's covenant a number that was wrong. The basis, the timing and the accrual clause cost three sentences, and a register's counsel that reads them has read the term that matters.

The escrow and the clawback

Under a deal-by-deal waterfall the share is paid on each realisation, and a fund whose early realisations succeed and later ones fail has paid the manager more than a whole-fund calculation would produce. The clawback corrects it at the end: the manager returns the excess. The clawback is a claim against the manager, an entity that has distributed the share to individuals, and the individuals have paid tax and spent; the claim is enforced against the individuals only where the constitution requires personal guarantees, and registers enforce those rarely and recover less. The escrow is the cure that pays: a stated share of each carried-interest distribution held in an account the manager does not control, released when the clawback can no longer arise, sized to the fund's loss profile. Both exist because the share was paid before the fund's outcome was known, and neither is needed under a whole-fund waterfall, which pays the share only when the outcome is known.

The continuation as both

A continuation vehicle's transfer price is a realisation for the old fund's waterfall and a valuation in substance, because the manager proposed it and the assets did not leave the manager's hands. A deal-by-deal share crystallised on the transfer price is a share paid on a valuation the manager set, and the continuation note's process, the independent valuation, the market check, the lead investor's negotiation, exists partly so that the price the share crystallises on is a price somebody other than the manager tested. Many continuations require the crystallised share to be reinvested in the new vehicle, so that the manager's money rolls with the holders' and the share is realised only when the new vehicle realises.

The land platform's valuations

A land platform's valuations move on consents and programmes more than on markets, and the exposure room on the Land door reads the valuation an investor can test: the consent assumed, the programme assumed, the evidence relied on. A platform whose manager's share accrues on a valuation that assumes a consent not yet granted has accrued a share on a forecast of a public authority's decision, and a platform that pays it has paid the manager for the authority's signature before the authority signed. The platform's constitution calculates the share on realised value after the charges a sale would bear, the Kingdom's ten per cent among them, and the developer's promote beneath the platform on the same basis, because a promote paid on a valuation is the same forecast paid twice.

The register's reading

A register that negotiated the rate down by two points and accepted calculation on net asset value has negotiated the wrong term, and a register that accepted the rate and required realised value, whole-fund timing and an accrual that is not payment has protected itself from the forecast.

By basis · by consequence	Realised value, whole fund	Realised value, deal by deal	Net asset value, accrued only	Net asset value, paid
When the share is paid	At the end, after all capital and hurdle	On each realisation, with escrow and clawback	Never on valuation; on realisation	On the valuation day
What it is paid on	Money received	Money received, position by position	Nothing until realised	A forecast
The cure if the forecast fails	None needed	Escrow and clawback	Reversal of the accrual	A claim against individuals
Land platform	The charge deducted; the promote beneath on the same basis	The same, per parcel	Reported; not paid	The consent paid for before it is granted
The register's reading	The safest	Acceptable with escrow	The accounting reality	The wrong term

A timeline, as a type

Year one: the constitution defines the share on realised value, whole-fund, with the accrual as an estimate; the land platform's waterfall deducts the charges and the promote; the administrator's schedule pays only on distributions. Year three: a consent lands; the valuation doubles; the accrual doubles in the accounts; nothing is paid; the committee reads the valuer's assumption about the programme. Year five: the programme slips; the valuation falls; the accrual falls; nothing has been paid and nothing is clawed back. Year seven: the parcel sells at a value between the two; the share is calculated on the realised net after the charge and the promote; paid from the distribution after all capital and the hurdle have gone to the holders. Year eight: the successor's register reads the predecessor's basis and accepts the rate.

The structure paper's page

The structure paper's economics page carries: the definitions of distributable gain and return of capital quoted; the basis, realised value; the timing, whole-fund or deal-by-deal with the escrow's size and the clawback's tests; the accrual clause; the land platform's deductions; the continuation's treatment of the crystallised share; the administrator's payment rule; and a worked example on three outcomes showing what is accrued and what is paid at each valuation day and each realisation. The page is the register's counsel's first reading, before the rate.

The worked example, annexed

The constitution annexes a worked example that shows, for a stated portfolio and three outcomes, the valuation at each year end, the accrual in the accounts, the realisations as they occur, the capital and hurdle returned, the share calculated and the share paid, with the clawback position where the waterfall is deal-by-deal. The example shows a valuation that rises and a realisation that falls short of it, so that the reader sees the accrual reversed and nothing paid on the forecast. An administrator computes from the example; a register reads it; a dispute is decided on it.

Income and the basis

A fund's income, rents, interest, dividends from positions, is realised value as it arrives, and a constitution says whether the manager's share is calculated on income as well as on gains from disposals. A real estate platform that holds for income has a manager whose share on income is calculated on cash received quarterly, which is real, and on disposals, which are real when they occur; a credit fund the same. Income is not a forecast, and a share on income is a share on money received; the distinction the basis draws is between cash and valuation, not between income and gain.

The manager's own accounts

A manager that books its accrued share as income in its own accounts has booked a forecast, and a manager whose own lenders or owners read that income as earned has a balance sheet that the fund's realisations may later contradict. Managers with whole-fund waterfalls book the share when it is paid or when it is reasonably certain, and a manager's own auditors read the fund's constitution for when that is. The basis in the fund's constitution is therefore also a fact about the manager's own financial reporting, and a manager that wants a clean balance sheet wants a clean basis.

Reading the basis with the lender

A net asset value lender's covenant is tested on the fund's net assets after the accrued share, and a share accrued on a valuation that the lender's own view discounts is a share the lender's calculation treats differently from the fund's. A facility that takes the fund's net asset value as its covenant base reads the accrual clause, because a fund that pays the accrual has reduced the lender's collateral by a forecast. The lender prefers the basis the register prefers, realised value and an accrual that is not paid, and a constitution that has it is a constitution the lender's counsel confirms.

The developer's promote, read with the basis

Beneath a land platform the developer's promote is a share of the parcel's gain above a hurdle, and the joint venture agreement is read for its basis as the platform's constitution is: realisation, or valuation. A developer that asks for its promote on the valuation at practical completion has asked for a share on a forecast of the sales, and a platform that grants it has paid the developer for units not yet sold. The promote crystallises on realisation, parcel by parcel, under the joint venture's waterfall, and the platform's own waterfall runs after it on the cash that reaches the platform. The two bases are the same or the platform has two forecasts beneath it.

A calculation, as a type

A fund with a whole-fund waterfall realises three positions over five years and holds two. At each valuation day the administrator accrues the manager's share on the net asset value after the hurdle, shows it in the accounts as a deduction from net assets, and pays nothing, because the constitution says the share is calculated on distributions of realised value after the return of all capital and the hurdle on all of it. In year five a consent lands on one of the held positions; the valuation rises; the accrual rises; nothing is paid. In year seven the position is sold below the valuation, because the programme slipped; the accrual is reversed to the realised figure; the share is paid on it. The holders received the capital and the hurdle before the manager received anything, and the forecast that was wrong cost nobody but the accounts a restatement.

The same fund on a deal-by-deal waterfall without escrow: the share is paid on each of the three early realisations; the two held positions fail; the clawback is a claim against the manager's individuals for money paid years before, and the register recovers a part of it.

Four cases, as types

A land platform's constitution calculates the manager's share on net asset value and permits payment on the valuation day. A parcel's consent is granted; the valuation doubles; the share is paid. The programme slips, the market turns, and the parcel sells at the pre-consent value. The share paid on the doubling is a payment for a consent that produced no realised gain, and the clawback is against individuals who have left the manager.

A manager's continuation sets a transfer price by its own valuation; the old fund's deal-by-deal share crystallises on it and is paid in cash; the new vehicle sells the assets three years later at a lower price. The old fund's cash holders were bought out at a price that paid the manager a share on a valuation the manager set.

A fund's administrator treats the accounting accrual as payable and distributes it at each year end, because the constitution does not say the accrual is not payment. The fund's final realisations are lower; the accrued and paid shares exceed the whole-fund entitlement; the constitution's clawback, drafted for deal-by-deal realisations, does not clearly reach payments of an accrual.

A fund's constitution states the basis as realised value, the timing as whole-fund, and the accrual as an accounting entry and not a right; the land platform beneath it deducts the disposition charge and the developer's promote on realisation; the continuation's transfer price is tested and the crystallised share is reinvested. The manager is paid for what it did, when the money arrived.

What each party holds

The manager holds the basis and the timing it agreed, and the discipline of treating the accrual as an estimate.

Counsel holds the constitution's definition of distributable gain and return of capital, the timing provision and the accrual clause.

The administrator holds the calculation on realised value and the accrual in the accounts, and pays nothing on a valuation.

The valuer holds the forecast, with its assumptions stated.

The committee holds the reading of the valuation and, on a continuation, the tested price.

The register holds the basis and the timing, which it read before the percentage.

The sequence

1. The constitution defines distributable gain and return of capital as realised value, in terms.
2. The timing is whole-fund, or deal-by-deal with an escrow sized to the loss profile and a clawback with interim tests.
3. The accrual clause states that the accounting accrual is an estimate and not a right to payment.
4. The land platform's waterfall and the developer's promote are calculated on realised value after the charges a sale bears.
5. The continuation's transfer price is tested by the continuation's process, and the crystallised share is reinvested where the lead requires.
6. The administrator's service schedule says the share is paid only on distributions of realised value.

Questions a manager asks

Is accrual on valuation wrong. Accrual is what the accounting standards require; payment on accrual is what the constitution must forbid.

Does whole-fund timing delay the manager's share too long. It pays the share when the fund's outcome is known, which is late; the deal-by-deal alternative pays earlier with an escrow and a clawback, and the register chooses which it will accept.

What about a consent that genuinely transforms a parcel. The valuation rises and the accrual with it; the share is paid when the parcel is sold at the transformed value, which is when the transformation is real.

Can the continuation's transfer price be treated as a realisation. It is one for the old fund's waterfall; the process exists so that the price is tested and the crystallised share is reinvested rather than paid on a number the manager set.

What does the register negotiate first. The basis and the timing; the percentage last.

Who enforces a clawback. The register, against the manager and, where guaranteed, the individuals, rarely and with partial recovery; the escrow is the cure that pays.

The register reads the basis and the timing before it reads the percentage. The percentage is a negotiation; the basis decides whether the percentage means anything, and a register that has read the basis, the timing and the accrual clause has read the whole of the manager's economics in three sentences.

Terms used

Realised value: cash received by the fund from realisations and income, as opposed to valuation.

Whole-fund waterfall: the calculation of the share on the fund as a whole after all capital and hurdle are returned.

Deal-by-deal waterfall: the calculation on each realisation, corrected by escrow and clawback.

Accrual: the accounting recognition of the manager's contingent share on net asset value, which is not payment.

Escrow: a share of each carried-interest distribution held back until the clawback cannot arise.

Crystallisation: the point at which the manager's share becomes payable on a realisation.

What to read

The constitution's definitions of distributable gain, return of capital, hurdle and the manager's share, its timing provision and its accrual clause; the accounting standards' treatment of carried interest; the administrator's service schedule; the continuation's process; the land platform's waterfall and the joint venture's. On this site, the economics room under Structures and the platform and exposure rooms on the Land door.