What is Carried Interest?
Carried interest, also known as carry, is a form of private equity compensation for general partners and employees. It rewards them for their excellent work generating a return, or profits, for a pool of capital that they’ve been responsible for investing, managing, and then divesting. Private equity firms are often seen as legal structures comprised of general partners (GP), limited partners (LPs), and employees. GPs are private equity managers and investors and are responsible for managing the fund’s investments. They usually contribute a portion of the total fund’s capital, typically around 1% to 5%. Though GPs charge a yearly management fee to LPs (usually 2%), the main incentive is carry, which is a proportion of profits. This is to align interests and entice strong positive performance. The standard carry percentage for a GP is approximately 20% (20% of profits after the initial hurdle rate), as well as the management fee. LPs are external investors (think pension funds, insurance companies, endowments, HNWIs, etc.) who have priority over the fund’s initial profits. Employees, including investment professionals like partners, principals, VPs, and associates, are typically allocated a portion of the GP’s carried interest as compensation. All of these vary based on the fund’s structure and agreement with the LPs, set out in a Limited Partnership Agreement (LPA).
Types of Carried Interest
A distribution waterfall defines the order in which profits from a GP/LP investment relationship are allocated. Here are 4 examples:
European Waterfall
A European-style waterfall, also known as global-style, is a more conservative approach for LPs that focuses on the whole fund. The GP only receives their carried interests after each of the LPs in the private equity fund has received their capital contribution as well as their preferred return, also known as the hurdle rate. A true European waterfall will guarantee that carried interest is paid after all investments are exited; however, there can sometimes be some other variations. For example, individual investments exit after all initial contributions have been returned to LPs.
Example
A private equity fund uses a European waterfall structure with an 8% preferred return and a 20% carried interest rate. The fund has realised profits of £100 million. You can calculate the LP’s preferred return by multiplying the realised profits of £100 million by 8%, which equates to £8m. This then leaves the remaining profits at £92m. Therefore, you’ll then calculate the GP’s carried interest by multiplying £92m by 20%, which equates to £18.4 m. The LP would receive the remaining £73.6m in profits.
American Waterfall
An American-style waterfall differs from its European counterpart because it is applied on a deal by-deal basis instead of looking at the fund as a whole when providing carried interest. This works because the GP will receive their carried interest once each investment generates a profit. This means they don’t have to wait for all investments to be liquidated first. This is the basic way the American waterfall works, but like the European distribution, it can have variations too. For example, it can sometimes include a ‘clawback’ provision where the GP has to return carried interest if subsequent investments don’t perform well and the whole fund’s returns fall below the hurdle rate.
Example
A private equity fund uses an American waterfall structure with an 8% preferred return and a 20% carried interest rate. After the first investment, the fund realises profits of £10m. You can calculate the LP’s preferred return by multiplying the realised profits of £10m by 8%, which equates to £800k. This then leaves the remaining profits at £9.2m. Therefore, you’ll then calculate the GP’s carried interest by multiplying £9.2m by 20%, which equates to £1.84m. This process will then continue after each of the other investments made in the fund.
Hybrid Waterfall
As you can probably guess from the name, a hybrid waterfall combines the European and American models. This distribution potentially involves the GP receiving some carried interest on a deal-by-deal basis, but it may be subject to a catch-up mechanism and a true-up at the fund level. This ensures the LPs still receive their capital and preferred return first. Like the two main waterfalls, a hybrid waterfall can have many variations. These will mainly be how the catch-up is structured and at what point the true-up occurs.
Example
The calculations will work in the same way as an American waterfall. However, if the GP missed out on some carried interest distributions on previous deals, the catch-up mechanism will allow them to receive additional distributions to reach their fair share. The true-up will also ensure the LPs receive their capital and preferred return before any further distributions are made to the GP.
Tiered Waterfall
Last but not least, we have the tiered waterfall structure. This approach involves including multiple hurdles or tiers, which are introduced where the carried interest percentage increases as the fund’s return surpasses certain thresholds. There are endless variations with this type of carried interest, with different levels of returns leading to different carried interest splits.
Example
A private equity fund has a tiered waterfall structure consisting of three tiers:
- Tier 1: 8% preferred return with a 10% carried interest rate
- Tier 2: 12% preferred return with a 20% carried interest rate
- Tier 3: 15% preferred return with a 30% carried interest rate
Calculations are similar to those of other waterfalls and can be used to calculate the distribution of a fund with realised profits of £20 million. You can calculate the LP’s preferred to return by multiplying the realised profits of £20 million by 8%, which equates to £1.6 million. This then leaves the remaining profits after the tier 1 hurdle at £18.4 million. LPs will then receive their 12% preferred return on the remaining profits of £2.208 million, which can be calculated by multiplying £18.4 million by 12%. This then leaves the remaining profits after the tier 2 hurdle at £16.192 million. Therefore, you’ll then calculate the GP’s carried interest at the tier 3 rate by multiplying £16.192 million by 30%, which equates to £4.8576 million.
Factors Affecting Carried Interest
You now know the different types of carried interest private equity fund managers might adopt, but what other factors affect it? Here are some examples:
Fund Size and Term
The duration and amount of carried interest a GP and its employees will receive depends on the private equity fund’s size and term. For example, larger funds will generate higher carried interest amounts as they invest more capital. A 2x MOIC on a £1bn fund, compared to a £100m fund, is significantly larger. But what matters is what % of carry allocation you are entitled to receive. Longer terms give GPs more time to generate and realise profits for their investments, but that also increases the time you have to wait to receive your share of carried interest. With a private equity fund that has a true European Waterfall structure, you will have to wait the period it takes to invest the pool of capital fully (e.g., 2 years), hold and manage the investments (e.g., 3-5 years), and divest the entire portfolio (e.g., 2 years). In this example, assuming you won’t receive carry payouts for seven years would be reasonable. Fund terms vary. It’s important to consider the time value of money for yourself and find a length that you’re happy with.
Structure
As we mentioned above, carried interest has a wide range of different structures, from whole funds to deal-by-deal approaches. The type of waterfall a private equity firm chooses can affect how much carried interest a GP receives, but mainly when they receive it.
It’s also good to note that some waterfalls allow for interim distributions before the final liquidation of the private equity fund, with varying terms on how these are handled.
Vesting
Carry can be subject to vesting for managers and employees, similar to stock options. You may have been given a 5% carry allocation that vests over 5 years. That means that for each year you work for the fund, you vest 1/5 or 20% of your 5% allocation, in this case, 1% per year. If you were to leave before that term is over, you would only be entitled to keep the number of years vested.
Money at Work Calculation
This is where you are communicated an amount of capital that you have been allocated into the fund, e.g., £500k. You can divide this by the total fund size to calculate your percentage allocation.
Percentage of Funds
You are provided with a percentage allocation in the fund. Keep in mind that you need to be clear on what pool of capital this is a percentage of: the whole fund amount, the GP stakes, or others.
Basis Point Allocation
These tend to be more granular and can result in dilution based on the number of employees the fund grows to have. Often, there will be a percentage allocation to the GP, and each individual at the fund will receive a portion of this based on their seniority or basis point allocation. This structure makes your carried payout much more difficult to calculate and will change as the team does.
Final Thoughts
When calculating carry amounts, there is often a 2x multiple assumed, though what is achieved varies significantly across the industry. There is contention to “it’s easier to achieve a higher multiple with smaller pools of capital”. The amount of carry you receive is usually based on your seniority at the time of funds raised. This can often lead to frustration and something you want to pre-emptively have a conversation about, especially if the fund is raised shortly before you’re eligible for carry or about to receive a promotion that would entitle you to a much higher share. For carried interest to be calculated accurately, you need to know many details about the payout structure/agreement between the GP and LP. So ask many questions, and think about your compensation holistically, and over the course of a fund life, rather than individual years.
