Private equity managers’ fees: estimation and sensitivity analysis using Monte Carlo simulation

Private equity managers’ compensation is a particularly problematic area in terms of its tax treatment in the United States and some European countries. This problem originates from the difficulty of defining the particular forms of incentive and therefore their estimated fair value. Based on the literature, carried interest, which is one of the most common profit-sharing arrangements observed in practice, may be considered as an option characterized by several constraints. The use of classical option-pricing models is inappropriate for taking all these constraints into account. The contribution of this paper is to propose a suitable model to estimate the expected compensation of fund managers and to test the effect of fund characteristics and profit-sharing rules on its fair value. We use the Monte Carlo simulation model and take into account the non-marketability criteria of the carried interest. A sensitivity analysis is performed in order to show the evolution of the carried interest value. The results importantly show the sharp differences between carried interest distributed in the case of venture capital and that in the case of buyout funds and show the importance of the claw-back clause for “deal by deal funds”.