How Carried Interest Works (Examples & Calculations)

Carried interest is a key concept in the world of private equity, hedge funds, and other alternative investment vehicles. It refers to the share of the profits that fund managers or general partners (GPs) receive as compensation for managing the fund. This is typically a percentage of the profits above a specified threshold, known as the hurdle rate, and it incentivizes fund managers to maximize the value of the investments they manage.

In this article, we will dive into the mechanics of carried interest, how it is calculated, and provide examples to help clarify how it works in private equity funds.

What is Carried Interest?

Carried interest is the portion of a fund's profits that is allocated to the fund's general partners, typically after the limited partners (LPs) have received their initial investment back, along with any preferred return (hurdle rate). It serves as a performance fee for the fund managers, rewarding them for generating returns above a certain threshold.

In simpler terms, it’s a performance-based compensation that aligns the interests of the general partners with those of the limited partners. If the fund performs well and generates returns above the agreed-upon threshold, the general partners are rewarded with a percentage of the profits.

How Does Carried Interest Work?

The Basic Structure of Carried Interest

1. Fund Contributions:
   • Limited Partners (LPs): Typically, LPs provide the majority of the capital for the fund.
   • General Partners (GPs): The GPs contribute a smaller portion of the capital but manage the fund and its investments.
2. Hurdle Rate:
   • The hurdle rate is the minimum return that LPs must receive before the GPs can start receiving carried interest. It is often set at a fixed percentage, such as 8% annually.
   • If the fund generates returns below the hurdle rate, the GPs receive no carried interest.
3. Profit Split:
   • Once the hurdle rate is met, the profits are typically split between the LPs and GPs. The GPs typically receive 20% of the profits above the hurdle rate, while the LPs receive the remaining 80%.
4. Catch-Up Clause:
   • Some funds include a catch-up clause, which allows the GPs to "catch up" and receive a larger portion of the profits until they’ve earned their agreed-upon share. This is often used to ensure that GPs receive their full 20% carried interest after the LPs have received their preferred return.
5. Excess Profits:
   • Once the LPs have received their hurdle return and the GPs have received their carried interest, any remaining profits are split according to the original agreement, which is often an 80/20 split between LPs and GPs.

Example of Carried Interest in a Private Equity Fund

Let’s walk through a simple example to better understand how carried interest works in practice.

Fund Details:

• Total Fund Size: $100 million
• Hurdle Rate: 8% annually
• Carried Interest for GPs: 20% of profits above the hurdle rate
• Investment Period: 5 years

Scenario 1: Fund Generates $50 Million in Profits

1. LPs' Share:
   • LPs are entitled to receive their original $100 million investment back first. Afterward, they need to receive a return based on the hurdle rate of 8%.
   • Over 5 years, the 8% hurdle rate would accumulate as:
     8% × 100million = 8 million annually
     • For simplicity, let’s assume an 8% annual return over the 5 years, so LPs would get $40 million (8% of $100 million per year for 5 years).
2. Carried Interest Calculation:
   • Once the LPs have received their original capital plus the hurdle return of $40 million, the next $10 million in profit (assuming total profits of $50 million) will be split between the LPs and GPs.
   • The GPs' share: The GPs receive 20% of this $10 million in profit, which amounts to $2 million.
   • The remaining $8 million of profit will go to the LPs.
3. Total Distribution:
   • LPs: They receive their original $100 million back, the $40 million in hurdle returns, and the remaining $8 million in profits. Total for LPs = $148 million.
   • GPs: They receive the carried interest of $2 million.

Scenario 2: Fund Generates $120 Million in Profits

Let’s assume that the fund performs exceptionally well, generating $120 million in profits.

1. LPs' Share:
   • LPs still receive their original $100 million plus the $40 million hurdle return, totalling $140 million.
2. Carried Interest Calculation:
   • With $120 million in profits, after giving LPs their full hurdle return, the remaining $80 million of profit is available for distribution.
   • The GPs receive 20% of the remaining profit, which amounts to $16 million.
   • The LPs receive the remaining $64 million.
3. Total Distribution:
   • LPs: $100 million (original investment) + $40 million (hurdle return) + $64 million (profit) = $204 million.
   • GPs: $16 million (carried interest).

Tax Considerations of Carried Interest

One important factor that affects carried interest is the tax treatment. In many jurisdictions, carried interest is taxed at a capital gains rate, which is typically lower than the ordinary income tax rate. This provides a tax advantage for general partners, as they benefit from a lower tax rate on their profits. However, there has been ongoing debate and potential regulatory changes around the taxation of carried interest.

Why Carried Interest Matters

Carried interest is a key incentive for private equity fund managers, aligning their interests with those of the limited partners. Since the general partners only receive carried interest after the fund has met the hurdle rate, they are motivated to maximize the fund’s performance and generate high returns. This structure ensures that both parties benefit when the fund performs well.

For institutional investors, understanding how carried interest works is essential, as it affects the potential returns from their investments in private equity funds. While carried interest provides an incentive for fund managers, it also means that investors must factor in the impact of performance fees on their net returns.

Conclusion

Carried interest is a central component of private equity and alternative investment structures. It is designed to reward general partners for generating profits above a minimum threshold, ensuring that fund managers remain incentivized to maximize the value of their investments. Through careful structuring, carried interest aligns the interests of both general and limited partners and plays a key role in the overall success of a fund.

Understanding how carried interest works, along with its calculation, is crucial for both fund managers and institutional investors looking to navigate the world of private equity investments.

FAQs

1. What is the typical percentage of carried interest for GPs?
Carried interest is typically set at 20% of the profits above the hurdle rate. However, this percentage can vary depending on the fund’s structure and the agreement between the general partners and limited partners.

2. What is a hurdle rate in carried interest?
The hurdle rate is the minimum return that the fund must achieve before the general partners are entitled to receive carried interest. It is typically set as an annual percentage return, often around 8%.

3. How is carried interest calculated?
Carried interest is calculated after the limited partners receive their initial capital back and the agreed-upon hurdle return. Once this is achieved, the general partners are entitled to a percentage (typically 20%) of the profits above the hurdle rate.

4. Is carried interest taxable?
In many jurisdictions, carried interest is taxed at the capital gains rate, which is usually lower than the ordinary income tax rate. However, this tax treatment has been a subject of debate and could be subject to changes in tax laws.

5. Why is carried interest important in private equity?
Carried interest aligns the interests of the general partners (GPs) with those of the limited partners (LPs) by incentivizing GPs to maximize the fund's performance. Since GPs only earn carried interest if the fund exceeds the hurdle rate, they are motivated to deliver high returns for investors.