Carried Interest

What is carried interest?

Carried interest is the performance or incentive fee in a private equity fund that is paid to the general partners.

Private equity funds are largely structured as limited partnerships with a general partner (GP) and limited partners (LPs). The GP creates, administers, and manages the fund, while also being responsible for managing the investments. The LPs provide the capital and thus serve as the fund’s investors.

General partners are compensated for their operational role by a management fee, charged as a percentage of the fund’s assets. They are compensated for their investment management role by a performance fee, charged as a percentage of the fund’s profits above a certain amount. A typical fee arrangement for GPs is the “2 and 20” fee schedule, which pays the GP a 2% management fee on assets and 20% of the profits on the investments.

The performance fee gives the GP an incentive to maximise the returns to investors. That way the GP has “skin in the game” in the form of an ‘interest’ in the fund’s performance. This is accepted by fund investors as an assurance that the GPs interests are aligned with theirs. Since the ultimate profit in the overall fund will not be precisely known until all investments have been liquidated, the interest of the GP is ‘carried’ throughout the fund’s life.

The GP’s carried interest begins accruing as assets in the fund are sold. It is not usually paid out, however, until the investors receive their investments back plus a minimum expected return, known as the ‘hurdle rate’. Once the hurdle rate is achieved, the fund can begin paying the GP part of its performance fee in accordance with the rules set out in the investment agreement for the fund.

Carried interest thus moves up and down as assets are sold and profits calculated but cannot be precisely determined until all assets have been liquidated.

Key Takeaways

• Carried interest represents the performance fee for the GP in a private equity fund.
• Investors are usually guaranteed a return of their capital plus a minimum hurdle rate of return before the GP shares in profits.
• Carried interest aligns the interests of the LPs with those of the GP in a private equity fund.

Carried interest in Private Equity and Venture Capital

Carried interest compensates the GP and managers of a private equity or venture capital fund with a percentage of the profits on the fund’s investments. This performance fee pays the managers in a way that provides an incentive to maximise the fund’s profits for the investors and is only paid once the fund has returned the investors’ capital and surpassed a minimum hurdle rate of return.

The incentive arrangement, the hurdle rate, and the priority of payouts to the GP from investment proceeds are all detailed in the fund’s investor agreement along with a “distribution waterfall” that outlines how the proceeds of asset sales are to be divided between the LPs and the GP. The waterfall schedule ensures that all proceeds from the fund’s assets are directed either to the LPs or the GP in a manner that satisfies the investment agreement. (It should be noted that waterfall schedules may differ slightly between the US and Europe in their process but both have the same objective.)

Measures of fund valuation and performance, such as IRRs or MOICs are published net of carried interest.

How to calculate carried interest?

The following hypothetical example illustrates how carried interest is calculated.

Assumptions:

ABC Private Equity Fund #1

Total investment: $100 million

Hurdle rate: 8%

Final value after all assets have been liquidated: $140 million

GP performance fee: 20%

Since the final fund value exceeds the 8% hurdle rate, the GP is entitled to receive the carried interest.

Calculations:

Total fund profits = Final Value – Total investment

                             = $140 m - $100 m

                             = $40m

‍

Carried interest = Total profit * Performance fee

= ($40m) * (20%)

= $8m

The remaining profits of $32m go to the LPs.

How is carried interest taxed?

Carried interest is viewed for tax purposes as a return of capital and is therefore taxed at the long-term capital gain rate (currently a maximum of 20%). To be eligible for this rate, the carried interest must be held for at least 3 years.

Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. Private equity is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.