1. This article discusses some of the primary consid-
erations for partners of private equity funds, and
their counsel, on the topic of estate planning with
interests in private equity funds. The article re-
views Section 2701 and its effect on planning with
interests in private equity funds, and goes on to
highlight the mechanics and valuation methodol-
ogy for the capital interest portion of partners’ in-
terests.
Planning with interests in private equity
funds is enticing because of the opportunity to
transfer a portion of a partner’s share of the
carried interest, an asset with potential for
great appreciation. However, because of con-
cerns about running afoul of Section 2701,
many estate-planning transfers of carried in-
terest also include the transfer of an equal share
of the partner’s capital interest in the fund.
This is the transfer of a “vertical slice.” An ear-
lier article addressed the factors that estate
planners and their clients need to be aware of
when transferring carried interest at the start of
a private equity fund.1
If a client transfers a ver-
tical slice, the client and counsel also need to be
aware of the complexities and valuation con-
siderations involved with transferring capital
interests in the fund. Capital interests are com-
prised of a share of the fund’s net asset value
(NAV), subject to the obligation (on the gen-
eral partner entity’s request) to contribute any
remaining unfunded capital commitment to
the fund. Capital interests held by a partner in
the fund are typically comprised of either cash
capital, synthetic capital (sometimes called fee
waiver or deemed contributions) or some
combination of the two. It is important to un-
derstand the difference between them, and to
consider the risk of transferring synthetic cap-
ital. How does synthetic capital differ from
cash capital? What risks are inherent in trans-
ferring a synthetic capital interest? How is a
cash capital interest valued, and how does the
valuation of synthetic capital differ? These are
important questions for private equity fund
Because of the
risk of running
afoul of Section
2701, most
estate planning
transfers of
carried interest
also include the
transfer of an
equal share of a
partner’s capital
interest, which is
known as a
vertical slice.
BRYCE A. GEYER, CFA, ASA, is a Vice President of FMV Opinions, Inc. and he co-heads the firm’s alternative investment management prac-
tice. He specializes in valuing interests in private equity, venture capital, and hedge funds, and he regularly provides opinions of value of carried
interest, capital interests, management-fee-waiver interests, and of entire firms. He may be reached at bgeyer@fmv.com or (415) 288-9500.
NATHAN M. GALLAGHER, ASA, is a Vice President of FMV Opinions, Inc., and is located in the firm’s New York office. Mr. Gallagher has ex-
tensive experience in a diverse range of valuation assignments, including determining discounts for lack of control and lack of marketability for
interests in business entities, and valuing debt instruments, preferred stock, limited partner interests in private equity and hedge funds, restricted
and other illiquid blocks of common stock, and other nontraditional business interests. He may be reached at ngallagher@fmv.com or (212) 697-
4378.
ESTATE PLANNING
WITH THE PRIVATE
EQUITY VERTICAL
SLICE
BRYCE A. GEYER AND NATHAN M. GALLAGHER
265PRACTICAL TAX STRATEGIESJUNE 2016 265PRACTICAL TAX STRATEGIESJUNE 2016

2. partners to consider before they transfer a ver-
tical slice of their interests in a fund.
Section2701’sapplicabilitytoprivateequity
funds
Section 2701 provides rules for determining the
value of intra-family transfers of interests in cor-
porations or partnerships that include senior/pre-
ferred equity interests and common/junior equity
interests. Specifically, the section guards against
transfers of common/junior interests in the case
when an applicable family member holds an ap-
plicable retained interest after the transfer (i.e., a
senior/preferred interest). Although Section 2701
does not make reference to interests in private eq-
uity funds, many estate planning professionals be-
lieve it may be applicable to transfers of carried
interest from one generation to the next. This is
because, in accordance with the allocation of dis-
tributions (the waterfall) set forth in the fund’s
partnership agreement, carried interest distribu-
tions are usually subordinated to returns to the
capital interest holders in the fund. In other
words, the carried interest represents a junior or
common interest and capital interests represent
senior or preferred interests. While specific water-
fall provisions may differ from fund to fund, the
following is a typical example:
1. 100% to limited partners until they have re-
ceived distributions equal to the amount of
capital invested in such investment, plus any
unreturned capital of previously realized in-
vestments (return of capital).2
2. 100% to limited partners until they have re-
ceived cumulative distributions equal to an 8%
per annum return on their contributed capital
(preferred return).
3. 100% to the general partner until it has re-
ceived an amount equal to 20% of the sum
of: (a) the preferred return distributions, and
(b) the distributions made in this third stage
(catch up).
4. Thereafter, 80% to the limited partners and
20% to the general partner (profit split).
In this waterfall, the carried interest repre-
sents the general partner’s share of the distribu-
tions made in the catch up and profit split stages
and it is thus subordinate to the return of capital
and preferred return. The return of capital and
preferred return represent priority payments to
capital interests of the fund (including cash cap-
ital interests held by the general partner), thus
making such interests senior in priority to the
carried interest. It is this priority of returns, in
which the carried interest is junior and capital
interests are senior, that cause estate planning
professionals to fear that the IRS and the Tax
Court will apply Section 2701 to transfers of car-
ried interests. In the event that Section 2701 is
applied to the transfer of a carried interest by it-
self, the tax consequences could be severe (in
essence, the IRS would assign the value of an
equal portion of the taxpayer’s senior/preferred
interest, namely the capital interest, to the trans-
ferred portion of the carried interest).
Section 2701 valuation rules do not apply if
the transfer includes a proportionate share of
both the common and preferred interests of
the entity. Accordingly, to avoid the risk that
Section 2701 would apply to the transfer of a
carried interest, estate planners could counsel
clients to give equal shares (i.e., a vertical slice)
of their rights to the carried interest and their
capital interest in the fund.3
Such capital inter-
ests include the partner’s share of the general
partner’s capital interest in the fund and any
direct limited partner interest they may have in
the fund (these interests are collectively re-
ferred to as the partner’s capital interest here-
inafter), which would then need to be valued in
the context of the transfer. Having taken steps
to avoid the Section 2701 problem, one now
266 PRACTICAL TAX STRATEGIES JUNE 2016 VERTICAL SLICE
Planning with interests in private equity
funds is enticing because of the opportunity
to transfer a portion of a partner’s share of
the carried interest, an asset with potential
for great appreciation.
1
Geyer, “Carried Interest: Reducing the Risk of Audit,” 93
PTS 33 (July 2014).
2
This stage often also includes a return of capital that has
been contributed for management fees and other fund ex-
penses.
3
In addition to the vertical slice exception, some practitioners
have espoused other ways of transferring the economics of
the carried interest without running afoul of Section 2701.
Examples include the carry derivatives used by David Han-
dler and his team at Kirkland & Ellis LLP, and nonvertical
planning techniques written about by N. Todd Angkatavan-
ich and David A. Stein at Withers Bergman LLP. It is impor-
tant to note that the management company is not generally
included within the vertical slice discussion because it
simply receives a management fee from the fund for its man-
agement activities. In this regard, it is not a part of the jun-
ior/senior structure of the fund’s investment returns. An ex-
ception arises in the rare case when the management
company and the general partner are the same entity and
the management company thus receives the carried inter-
est. Discussion of this scenario is beyond the scope of this
article.

3. must contend with the complications arising
from transferring a capital interest.
Characteristicsofcapitalinterests
As noted above, capital interests are comprised of
a share of the fund’s NAV, subject to the obligation
to contribute remaining unfunded capital com-
mitments to the fund. Cash capital interests, which
can be held by both general partners and limited
partners, are those in which the holder of the inter-
est fulfills his or her capital commitment through
cash contributions. Synthetic capital interests,
which are generally held by only general partners,
are those in which the holder of the interest has its
capital contributions fulfilled by contributions
from the fund’s limited partners. These contribu-
tions are deemed to offset a corresponding portion
of management fees owed by the limited partners
(giving rise to the name “fee waiver”).
There are several issues that make a capital
interest undesirable for estate planning trans-
fers. First, the investment return on the capital
interest will approximate the investment return
on the fund’s investments—a lower rate of re-
turn than may be realized on the leveraged car-
ried interest. This makes it less attractive from
an estate planning perspective. Second, the cash
capital interest holder must fulfill its pro rata
share of future capital calls from the fund.4
If
such an interest is transferred to a trust, the
trust must have sufficient cash to be able to fund
its share of capital calls, at least until the point
when the fund has a realization event and capi-
tal is distributed. In general, private equity
funds have a five-to-seven-year investment pe-
riod and investments are typically held for at
least three or four years (usually longer), mean-
ing the capital interest holder will have several
years of funding capital calls without receiving
investment distributions. In many cases, a sig-
nificant majority of the capital commitment
will be called before the fund has a single invest-
ment realization. Some practitioners advise
clients to avoid this complication by creating a
contract in which the grantor agrees to fund all
future capital calls associated with the trans-
ferred capital interest. However, such a com-
mitment on the part of the grantor can add con-
siderable value to the gifted interest at the time
of the transfer (equal to the present value of the
expected future capital contributions).
It is generally accepted that it is possible to
avoid the complications created by transferring
the capital interest and still stay outside of the
Section 2701 limitations, if the client and coun-
sel plan early. Unlike carried interest, capital in-
terests do not have value until capital is invested
because, until this moment, the capital interest
is simply a capital commitment. A capital com-
mitment obligates the interest holder to fund
up to that amount of capital on request by the
general partner entity of the fund, and thus, is a
liability from the capital interest holder’s per-
spective. On the other hand, once capital is
called for an investment, the capital interest
is comprised of a share of the fund’s NAV and
also of the interest holder’s remaining unfun-
ded capital commitment. While the owner of a
carried interest, in many cases, can receive up to
20% of the fund’s profits without investing any
capital, the owner of a cash capital interest will
simply have the obligation to exchange one
asset (cash) for another (a capital investment in
the fund)—and thus be exposed to the risk and
return attributes of the fund’s investments (as if
the owner had elected to make a different in-
vestment).
As discussed in greater detail below, limited
partner capital interests in funds trade in sec-
ondary markets, and they typically trade at dis-
counts to their pro rata share of a fund’s NAV.
Accordingly, at the start of a fund, before it has
made any investments and the fund has an
NAV of zero, there is no value associated with
the capital interest because it is comprised of
only the obligation to fund its share of future
capital calls. Therefore, clients can transfer a
vertical slice of their interests before any in-
vestments have been made, and thereby trans-
fer the capital interest while it has no value.5
Syntheticcapital:Addedcomplications
As indicated above, synthetic capital is the por-
tion of the general partner’s commitment for
267PRACTICAL TAX STRATEGIESJUNE 2016VERTICAL SLICE
4
As discussed below, this is not an issue with synthetic cap-
ital.
5
One complicating factor that is not discussed here is the fact
that the general partner’s capital interest typically does not
pay management fees or carried interest. In this regard, a
general partner’s capital interest is more valuable than a typ-
ical limited partner’s interest (which is subject to fees), with
the incremental value equal to the present value of avoided
future fees that otherwise would be paid by a normal limited
partner. However, in the authors’ experience, the present
value of these avoided fees is not enough to outweigh the li-
ability associated with future capital calls and the value of
such interest is still zero before the fund’s first investment is
made.

4. 268 PRACTICAL TAX STRATEGIES JUNE 2016 VERTICAL SLICE
which future capital calls will be covered by con-
tributions from the fund’s ordinary limited part-
ners, generally in the form of waived manage-
ment fees. Synthetic capital is used to change
what otherwise would have been ordinary in-
come (management fee income) into profits in-
terests, which are subject to capital gains taxes.
Synthetic capital becomes a profits interest be-
cause it is converted to an investment interest in
the fund that is subordinate to cash capital inter-
ests. Specifically, for a fund with a typical water-
fall (described earlier), returns to the synthetic
capital interest are usually subordinate to the re-
turn of capital and preferred return. In this way,
the synthetic capital is also said to be subject to
significant “entrepreneurial risk” because the
fund must generate enough investment return to
fulfill the preferred return hurdle on cash capital
contributions. However, clients and counsel alike
have grown increasingly concerned about the
fact that fee waivers, and all “disguised payments
for services,” have come under greater scrutiny
by the IRS in recent years.
In 2015, the IRS published proposed regu-
lations that might restrict the use of fee waiver
arrangements for private equity firms.6
The
proposed regulations provide guidance to
partnerships and their partners regarding
when an arrangement will be treated as a dis-
guised payment for services. In general, ar-
rangements in which payments to partners
are subject to significant entrepreneurial risk
are expected to be blessed by the IRS. How-
ever, the proposed regulations indicate that
certain fee waiver arrangements will not be
blessed, including “arrangements in which a
service provider either waives its right to re-
ceive payment for the future performance of
services in a manner that is non-binding or
fails to timely notify the partnership and its
partners of the waiver and its terms.” In this
regard, it appears that firms may run into
trouble when the fee waiver amount is not de-
termined in the early stages of the fund and
when it is subject to change. Also, it seems
that as long as the waiver amount is defined at
the outset of the fund, and given that it is sub-
ordinate to returns of cash capital (which in-
cludes the capital contributed by all normal
limited partners), and thus, exposed to signif-
icant entrepreneurial risk, such an arrange-
ment will be blessed by the IRS.
Having discussed the controversy associ-
ated with synthetic capital interests, it is im-
portant to note that there are also complexi-
ties associated with valuing synthetic capital
interests relative to cash capital interests. As
compared to a cash capital interest, synthetic
capital presents the added complexity that
the holder of the interest is under no obliga-
tion to fund capital calls with cash. Accord-
ingly, unlike a cash capital interest, the syn-
thetic interest will have value even before the
fund makes an investment, since it holds the
right to receive future distributions without a
corresponding obligation to fulfill capital
calls. However, this is mitigated to a certain
extent by the fact that the valuation of syn-
thetic capital, compared to a normal cash
capital interest, must take into consideration
the additional risk inherent in the profits in-
terest nature of the synthetic capital. Specifi-
cally, much like a carried interest, returns to
the synthetic capital have a right to distribu-
tions only if the return of capital and pre-
ferred return hurdles for cash capital inter-
ests are surpassed.
There is some debate in the estate planning
community as to whether the synthetic portion
of a partner’s capital interest can be gifted be-
fore it is used (i.e., before the corresponding
management fees are waived and used to fulfill
the partner’s capital call). Some practitioners
take the view that a gift is made by the partner
to the transferee at the time of each capital call
in which synthetic capital is used. This is at
least in part due to the fact that, in many funds,
if a partner resigns or retires, he or she will lose
the right to have future capital calls covered by
fee waivers. Any future capital calls will instead
require cash contributions by the holder of the
interest. This presents a similar problem as
planning with interests subject to vesting pro-
visions.7
If the existence or nature of an interest
is subject to a partner’s employment, some es-
tate planning professionals believe that gifting
such an interest, which can change in the fu-
ture, may prove problematic.
6
REG-115452-14.
7
Many estate planning practitioners believe that under Rev.
Rul. 98-21, 1998-1 CB 975, a transfer of an unvested inter-
est will constitute an incomplete gift for tax purposes.
It is generally accepted that it is possible to
avoid the complications created by
transferring capital interest and still stay
outside of the Section 2701 limitations, if the
client and counsel plan early.

5. Generalvaluation
methodologyforcapitalinterests
A typical waterfall structure for a private equity
fund was discussed above. The carried interest,
which has a significant upside in the event of out-
sized performance of the fund, but the potential
for no value if the fund underperforms, represents
the most volatile segment of the capital structure
of a typical private equity fund. In contrast, the
capital interests retain preferred priority to the re-
turns of the fund (including, in many cases, a re-
turn of capital, preferred return, and 80% of resid-
ual profits). In practice, there are two principal
ways to approach the valuation of a capital inter-
est, including the “discounted capital account
method” and the “discounted cash flow method.”
The discounted capital account method considers
that the value of a capital interest is linked to the
value of the underlying assets of the fund and it is
thus valued at a discount (or premium) to its pro
rata share of the fund’s NAV. The discounted
cash flow method is very similar, but is based on
the theory that an asset is worth the present value
of its expected future economic benefits (cash
flows). Each method is discussed in detail below.
Discounted capital account method. Because the
holder of a capital interest will generally8
receive a
“capital account statement” from the fund’s gen-
eral partner on a quarterly basis, such statement
is used as a starting point for the valuation. Con-
sistent with the U.S. Generally Accepted Account-
ing Principles (GAAP) requirements, the fund’s
general partner will assess the “fair values” of the
fund’s underlying portfolio assets. The general
partner will then compute a NAV for the fund as a
whole, and report the limited partner’s propor-
tionate share in the NAV in the form of a capital
account statement. As such, through the capital
account statement, the general partner will have
estimated values of the underlying assets of the
private equity fund, consistent with valuation
practices reviewed by the fund’s auditor. However,
there are two key considerations the appraiser
must bear in mind when using capital account
statements as a starting point for an analysis.
First, as previously discussed, the NAV of a
given fund, from which the capital account is
derived, will be assessed by the general partner
by estimating values for the fund’s individual
assets. The assets are valued at fair value, often
in accordance with principles issued by the In-
ternational Private Equity and Venture Capital
Valuation Guidelines. Under these standards,
an interest in a privately held business is gener-
ally valued as the fund’s pro rata share9
of the
value of the business as a whole (as if sold in its
entirety), while liquid securities (for example,
received in the context of an initial public of-
fering) are generally valued at the public stock
price. As a result, the NAV of the fund effec-
tively represents a controlling interest level of
value. A controlling interest in a closely held
entity has the power to effect changes in over-
all ownership structure and policies, business
strategies, management compensation, distri-
butions, and liquidation. A noncontrolling10
capital interest has little, if any, power to influ-
ence these items. Additionally, a noncontrol-
ling interest in a private equity fund suffers
from a lack of liquidity and marketability as
private equity funds restrict redemptions for
several years until investments are liquidated.
Even when a secondary market exists, such
markets are much less liquid than public secu-
rity exchanges. Accordingly, in determining
the fair market value (FMV) of a noncontrol-
ling capital interest in a private equity fund,
discounts for lack of control and lack of mar-
ketability are generally applicable to the capital
account balance.
Discounts. The appraiser might employ sev-
eral approaches to determine the appropriate
discount from NAV for the capital interest. As a
first step, it is appropriate to examine discount
indications from the secondary market for pri-
vate equity capital interests. This market repre-
sents transactions of partially or fully funded
cash capital interests in funds held by limited
partners, and thus, provides data useful (subject
to certain adjustments) for evaluating cash cap-
ital interests held by general partners. While
limited partner interests in private equity funds
are illiquid, a relatively large secondary market
of interests in private equity funds has evolved
over the years. Estimates of the size of the mar-
ket vary, with reported estimates ranging from
269PRACTICAL TAX STRATEGIESJUNE 2016VERTICAL SLICE
8
FMV Opinions, Inc. has accumulated broad experience valu-
ing capital interests in private equity funds, and this dicus-
sion will, for illustration purposes, often set forth terms that
the authors “generally” see. However, it is important to note
that private equity funds can employ a variety of terms.
9
Technically, the “pro rata share” would represent the pro-
ceeds received by the fund after the investment was sold fol-
lowing any applicable waterfall provisions.
10
It is important to emphasize that this discussion assumes
that a noncontrolling vertical slice was transferred—in other
words, the vertical slice did not include a general partner in-
terest that can control the fund. In the authors’ experience,
vertical slice transfers will include a minority (noncontrolling)
interest in the general partner’s interest, and thus, the inter-
est transferred (including the capital interest) will not be able
to exercise control over general partner entity or the fund.

6. $35 billion to $49 billion for 2014, up signifi-
cantly from a range of $22 billion to $36 billion
in 2013.11
Several companies that broker inter-
ests in private equity funds (such as Greenhill
Cogent, NYPPEX, and Triago, among others),
publish summary data on the price (as a percent
of NAV) at which interests trade in the second-
ary market. Discounts from NAV might vary
based on the type of fund, remaining unfunded
capital commitment relative to original com-
mitment, vintage year of the fund, and other
factors. Brokerage firms report summary, aver-
age data, without information on transactions
of specific funds. Generally, transactions take
place at a discount from NAV. For example, ac-
cording to a survey of secondary-market partic-
ipants conducted by the Dow Jones Guide to
the Secondary Market, 2015 edition, 76% paid
below NAV for interests in buyout funds, com-
pared to 89% for venture capital funds. In 2014,
a similar survey indicated 89% and 100%, re-
spectively.12
It is important to note that the secondary
market reflects prices paid as a percentage of
NAV. To the extent the price paid reflects a
discount, such discount likely incorporates the
detriment to the investor of a lack of control of
and marketability over the investment. How-
ever, since transactions take place subsequent
to the effective date of the NAV, investors will
likely make their own assessment of whether
there have been changes in the market values of
the underlying investments in the funds. Thus,
the magnitude of the discount can be signifi-
cantly affected by broader market conditions.
Given the lag in reported NAVs for private eq-
uity funds, in the context of appreciating mar-
ket conditions, buyers may price in estimated
increases in NAV in the price paid. Further, a
rising market may provide more exit opportu-
nities for the private equity fund—and result in
a shorter investment horizon for the capital in-
terest holder. All else equal, the shorter the re-
quired holding period, the lower the discount
from NAV. Similarly, interests in funds at the
beginning of their investment period may
trade at relatively higher discounts, because in
addition to the fact that the purchasing in-
vestor will inherit the obligation to fund future
capital calls, the estimated holding period will
be relatively higher.
Discounts can also vary depending on the
fund strategy. According to Greenhill Cogent,
as a whole, private equity fund limited partner
interests traded at prices approximating NAV
in 2007, before collapsing to between 63% and
70% of NAV (reflecting a discount of between
30% and 37%) between 2008 and 2009. Pricing
then recovered to between 74% and 83% of
NAV between 2010 and 2012, before improv-
ing further to a range of 87% and 92% of NAV
between 2013 and 2015. Venture capital fund
interests have generally traded at prices be-
tween 10 and 20 percentage points below (i.e.,
representing a discount between 10 and 20
percentage points higher) that of buyout funds
over this period.13
In addition to consulting summary market
data, in some cases the appraiser will have ac-
cess to a broker with experience organizing or
negotiating secondary market transactions of
minority interests. In these cases, and provided
the fund is a large, well-known fund, the broker
may be aware of actual transactions of interests
in the fund. The number of transactions may be
limited, if there are any transactions at all (the
authors’ experience is that there is rarely more
than a handful of trades in a given quarter even
for large, well-known funds) and the time frame
in which the transactions took place may not
correspond to the valuation date. Nonetheless,
such direct market evidence can be extremely
valuable in assessing the appropriate discount.
Also, the depth of the market (or lack thereof)
can be informative regarding the lack of mar-
ketability for the investment.
As a second method to determine a discount
for lack of control and lack of marketability, ap-
praisers can apply an approach that isolates the
discounts for lack of control and lack of mar-
ketability. The lack-of-control discount can be
270 PRACTICAL TAX STRATEGIES JUNE 2016 VERTICAL SLICE
Capital interests present their own set of
complexities, including an understanding of
the differences between cash and synthetic
capital interests, remaining unfunded
commitments, and valuation considerations.
11
Guide to the Secondary Market, Dow Jones, http://images
.dowjones.com/wp-content/uploads/sites/43/2014/06/
10145724/SecondaryMarketGuide_2015.pdf, 2015 Edi-
tion.
12
Guide to the Secondary Market, Dow Jones, http://images
.dowjones.com/company/wp-content/uploads/sites/15/
2014/06/Guide_to_the_Secondary_Market_2014_Edition
.pdf, 2014 Edition.
13
Secondary Market Trends & Outlook, January 2016, Green-
hill Cogent, More detailed information on pricing for second-
ary interests in private equity fund can be obtained from
Greenhill Cogent, www.greenhill.com/business/capital-advi-
sory/secondary-advisory.

7. assessed by examining discounts from NAV for
closed-end funds similar in nature to the fund
examined, such as listed private equity funds.
Because listed private equity funds have quoted
market prices, and report values of their inter-
ests according to similar standards as private eq-
uity funds, the appraiser can analyze the NAVs
in comparison to the quoted trading prices to
evaluate the appropriate discount for lack of
control.14
Various approaches to isolating the
appropriate discount for lack of marketability,
including a comparative analysis of a database
of restricted stock transactions (such as the
FMV Restricted Stock Study),15
can also be
used. When estimating the appropriate discount
for lack of marketability, the appraiser should
carefully consider, among other things, the esti-
mated remaining investment horizon for the
fund, the volatility of the fund’s investments,
and broader market risk.
Discounted cash flow method. In contrast to
the discounted capital account method, which be-
gins with the capital interest’s pro rata share of the
fund’s NAV, the discounted cash flow method de-
termines value based on the present value of the
expected future cash flows of the capital interest.
This is particularly useful when determining the
value of a general partner’s capital interest, which
is typically not subject to management fees or car-
ried interest. This represents a benefit relative to
ordinary limited partner interests in the fund that
can make the general partner’s capital interest
more valuable than an ordinary limited partner
interest. Unlike the discounted capital account
method, the discounted cash flow method allows
for a direct quantification of this additional value.
The quantification can be done through two ap-
proaches of the discounted cash flow method.
The first approach considers all of the cash
inflows and outflows to the capital interest, and
determines the value of the interest based on
the present value of the future net distributions
to the interest holder. As discussed in “Carried
Interest: Reducing the Risk of Audit,” apprais-
ers work with the fund’s managers to create de-
tailed forecasts of the fund’s expected perform-
ance.16
Such forecasts include expected capital
contributions for investments and expenses,
holding periods of investments, and expected
investments returns. From these forecasts, the
appraiser is able to show the capital contribu-
tions expected to be made by the general part-
ner for its capital interest, and also the distribu-
tions of investment proceeds allocated to the
capital interest. The forecasted contributions
naturally capture the benefit associated with
the general partner’s capital interest not having
to pay management fees, because the contribu-
tions simply exclude such costs. Similarly, the
forecasted distributions naturally capture the
benefit associated with not having to pay car-
ried interest, because the general partner’s cap-
ital interest simply receives its pro rata share of
future investment proceeds, prior to calcula-
tion of the previously discussed distribution
waterfall. In this method, a discount rate is typ-
ically selected on a nonmarketable minority
level, after considering required rates of return
by investors in the secondary markets for inter-
ests in private equity funds. A variant of this
method is to select a controlling or marketable
minority rate of return, and then select appro-
priate discounts for lack of marketability or
lack of control to apply to the present value of
the cash flows.
The first approach under the discounted
cash flow method is useful for estimating the
expected holding period of the capital interest,
equal to the weighted-average time to receipt
of future cash flows (net of contributed capi-
tal). Additionally, it directly captures the liabil-
ity associated with the capital interest holder’s
requirement to fund future capital calls. As a
result, this method is also valuable in deter-
mining the value of a synthetic capital interest,
which, as previously noted, benefits from hav-
ing its capital contributions covered by the
fund’s ordinary limited partners. Accordingly,
the forecast for the synthetic capital interest in-
cludes only its share of future distributions,
without any corresponding detriment to value
associated with capital contributions.
It is important to note that the synthetic
capital interest also differs from a cash capital
interest in that it is subject to much more risk.
As previously mentioned, the valuation of the
synthetic capital interest must take into con-
sideration the additional risk inherent in the
profits interest nature of the synthetic capital.
Specifically, much like a carried interest, re-
turns to the synthetic capital generally have a
right to distributions only if the return of capi-
tal and preferred return hurdles for cash capital
271PRACTICAL TAX STRATEGIESJUNE 2016VERTICAL SLICE
14
However, careful analysis is also needed to assess whether
factors other than lack of control may affect the discount.
15
For more information on the FMV Restricted Stock Study,
see, “Determining Discounts for Lack of Marketability:
A Companion Guide to the FMV Restricted Stock Study,”
www.bvmarketdata.com/pdf/companionguide.pdf.
16
Note 1, supra.

8. 272 PRACTICAL TAX STRATEGIES JUNE 2016 VERTICAL SLICE
interests are surpassed. Therefore, the discount
rate used to determine the present value of the
cash flows is much higher than that used to de-
termine the present value of the cash flows for
the general partners’ cash capital interest.
The second approach under the discounted
cash flow method represents a combination of
the first approach and the discounted capital
account method. In this approach, the same
forecasts discussed above are used to deter-
mine the management fees and carried interest
that an ordinary limited partner interest would
be subject to over the life of the fund. The pres-
ent value of these fees, which are avoided by
the general partner’s capital interest, are then
added to the NAV of the general partner’s cap-
ital interest. As in the discounted capital ac-
count method, appropriate discounts are then
determined from this adjusted NAV. This
method is not applicable to synthetic capital
because it does not capture the benefit associ-
ated with the synthetic capital’s avoidance of
future capital contributions.
As a result of applying the second approach
under the discounted cash flow method to the
valuation of a general partner interest, the ap-
praiser will determine a discount from NAV
lower than for a limited partner interest in the
same fund. The difference in discount between
the two interests will be equal to the benefit of
avoided management fees and carried interest,
a benefit lacked by the limited partners.
Conclusion
While the transfer of carried interests in a private
equity fund may provide general partners with the
ability to transfer a large amount of potential ap-
preciation, the risks posed by Section 2701 have
prompted many estate planners to structure
transfers in the form of a “vertical slice.” Thus, the
taxpayer’s capital interests are included in the
transfer. Capital interests present their own set of
complexities, including an understanding of the
differences between cash and synthetic capital in-
terests, remaining unfunded commitments, and
valuation considerations. With a thorough un-
derstanding of these issues, taxpayers should be
able to confidently proceed with a vertical slice
transfer. n