Introduction
Carried interest, or 'carry,' represents a portion of the profits that the general partner (GP) or investment manager of a private investment fund—like those in private equity or venture capital—earns from the fund's investments.
It's not just compensation for the GP's expertise and dedication but also a mechanism to align the GP's interests with those of the investors. The structure of carried interest plays a crucial role in the economics of both individual deals and the fund overall.
The Fundamentals of Carried Interest
Carried interest is a share of the net profits—typically around 20%—that the fund distributes to the GP after the investors have received their initial investments back. This arrangement often kicks in only after achieving a minimum rate of return, known as the hurdle rate or preferred return.
The distribution of carried interest usually follows a "waterfall" model: LPs first recover their capital contributions and any preferred return. Subsequently, any additional profits are split between the GPs and LPs according to the terms set out in the fund's partnership agreement.
Example: Imagine a private equity fund that invested 50 million euros and has generated 100 million euros after all investments are liquidated. The partnership agreement stipulates that LPs are to receive their original investments back plus a preferred return of 20% on their investment, while the GP is entitled to a 20% carried interest. The investors would first receive 60 million euros (as a return of their capital and 10 million euros as a preferred return). The remaining balance would then be split between the investors and the GP. Out of those 40 million euros, the GP would receive 8 million euros, while the investors would receive an additional 32 million euros.
Variations in Carried Interest Structures
The way carried interest is applied—either on a deal-by-deal basis or across the entire fund—significantly influences the dynamics between the GP and investors:
Deal-by-Deal Carried Interest: In this setup, GPs can claim their profit share from each successful investment individually, possibly after achieving a preferred return, without considering the fund's overall performance. This could mean higher rewards for GPs but increased risk for investors. For example, if one investment yields substantial profits but others fail, GPs might still earn carried interest despite overall mediocre fund performance.
Example: A venture capital fund invests in five startups. One of these investments returns 10 million euros on a 2 million euros investment. According to a deal-by-deal carry structure, if the fund operates with a 20% carry (and there's no preferred return), the GP would immediately claim 1.6 million euros (20% of the $8 million profit) from this successful exit, even if all other investments go bust.
Fund Investment Carried Interest: When carried interest is calculated based on the fund's aggregate performance, it encourages a focus on long-term success. Only after all initial capital and, typically, a preferred return have been distributed to LPs, does the GP receive their share of any remaining profits.
Example: Using the same venture capital fund, let's assume that the fund’s total investment were exactly 10 million euros and has generated only 10 million euros in revenue. In this case, the GP would not benefit from any carried distribution as the investors would first recoup their initial investment.
The Role of Preferred Returns
The hurdle rate, or preferred return, is a target return that must be met before GPs can receive their carried interest. It ensures that investors see a predetermined return on their investment first, aligning GP incentives with achieving beyond just the minimum success threshold.
Conclusion
Understanding the nuances of carried interest is essential for both GPs and LPs in the investment world. It not only affects compensation but also influences investment strategies and risk management. By carefully structuring carried interest, funds can align the goals of GPs with those of the investors, ensuring a focus on long-term success and equitable distribution of profits.
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