Understanding Carried Interest
Carried interest is one of the most common terms used in private equity. ‘Carry’ is the percentage of the profits that the general manager – also known as the fund manager – receives as compensation from a private equity fund.
It’s the main way that general managers are paid for handling private equity investment funds.
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What is Carried Interest?
What is Carried Interest?
Carried interest is the share of profits that are passed onto the general partner responsible for managing hedge funds, venture capital, and private equity. It is the primary form of compensation for the general partner and aligns with the fund’s returns.
It’s an incentive for general partners to ensure investments meet their performance goals. Carried interest will only be paid if the fund meets its hurdle rate, otherwise known as the minimum return. General partners accept carried interest as it is typically taxed as long-term capital gain, at a lower rate, compared to ordinary income.
The Role of the General Partner
The Role of the General Partner
The general partner for an investment fund is typically a legal entity, rather than an individual. They take liability for the fund’s activities and are directly involved with the day-to-day operations of the business. It’s the general partner who carries the risk, rather than the investors, who are known as limited partners.
Within a general partner organisation, you’ll often have a “fund manager” who is responsible for managing the fund’s investments. However, these terms are often used interchangeably.
Carried Interest as Compensation
A fund’s general partner earns money in two ways, through carried interest and a management fee. This management fee is paid by the limited partners annually to cover expenses and overhead relating to the operation of the fund, including travel, office rent, and salaries.
The management fee is typically calculated as a percentage of the assessments under management (AUM) with most fees working out at 2% of the fund’s annual AUM. General partners may outsource the operational responsibilities to a private equity or venture capital firm, passing on the management fee to them.
How Carried Interest Works in Practice
Carried interest is the principal compensation for a fund’s general partner with the exact value depending on the fund’s returns. Most general partners will earn up to 20%, part of which is used to pay the fund’s manager. While a 2% management fee is paid annually, a general partner will only qualify for carried interest if the fund achieves its agreed minimum return.
Carried interest is, therefore, forfeited if the fund fails to meet this minimum return level. In this scenario, limited partners may be able to ‘clawback’ part of the carried interest paid to the general partner to make up for the shortfall between the fund’s actual performance and its minimum return rate. Not every fund will have a clawback provision in place.
Carried Interest Taxation
Most carried interest on investments is held for at least three years to allow it to qualify as long-term capital gains, and to give it a more favourable tax rate. There are both critics and supporters of this financial model, but there have been growing calls for changes to long-term capital gains taxation internationally.
Private equity and venture capital funds have a holding period that’s typically five to seven years.
European and American Styled Waterfall Scenarios
European and American Styled Waterfall Scenarios
Two common ways carried interest can be distributed – in either an American-styled waterfall or a European-style scenario.
American-style Waterfall
The carried interest is applied on a deal-by-deal basis, typically used for SPVs. General partners will collect the carried interest on each deal, meaning they won’t have to consider deal-specific losses unless a clawback clash is triggered. This method is typically used by venture capital firms.
European-style Waterfall
By comparison, the European-style waterfall method applies carried interest to the whole investment fund. This model is typically used by investment funds. The focus is on the overall portfolio returns, rather than looking deal-by-deal.
This style of waterfall carry does not usually have a hurdle rate with the investor’s capital being returned before the carried interest is collected. If there is a hurdle rate in place, all the capital and an additional percentage must be returned to investors before the carried interest can be collected.
Clawback
Some investment funds have a clawback clause that allows for money or assets to be reclaimed after being previously distributed. This clause is usually triggered if too much carried interest has been collected or if a clerical error has been made.
The clawback clause is usually put in place as a safety net for limited partners if the fund fails to make a certain return. If the fund fails to make the pre-agreed return, the limited partners can ‘clawback’ the difference from the general partner.
Vesting
Carried interest may be subject to vesting in larger venture capital firms. It’s similar to how stock options vest for employees. The purpose of vesting is to encourage employees to remain with the venture capital firm long-term. If a general partner is entitled to a 10% carried interest allocation over a five-year holding period but leaves before the end of this period, they’ll only be entitled to the amount vested during the time they are with the VC firm.
Private Equity FD and CFO Recruitment
FD Capital is the UK’s leading financial recruitment agency, connecting start-ups and SMEs with FDs and CFOs who have experience working within the private equity industry. Our talent pool includes senior financial executives available to work on a part-time, full-time, and interim basis in-house and remotely.
Our leadership team is made up of financial executives, entrepreneurs, and business leaders who understand both sides of the recruitment process. We bring a unique insight to the FD and CFO recruitment process.
Start the process of recruiting a private equity CFO or FD today by contacting our team at recruitment@fdcapital.co.uk or 020 3287 9501.
Why Carried Interest Matters
Carried interest is an important aspect to funding and how Private Equity operates.
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