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16 April 2020

Everything A PE Professional Should Know About Carried Interest in 5 Minutes

Carried interest or carry is the share of the profits of an investment received by the investment manager over the amount contributed to the partnership in private equity and hedge funds as well. The manager receives the interest upon a successful exit from an investment. It gets counted as the performance fee rewarded to the manager for improving performance.

In the private equity industry, the standard carried interest rate is 20 percent for funds making buyout and venture investments. However, certain big shots like Bain Capital provide 25 to 30 percent of carried interest.

How does the manager or general partner receive carried interest?

The general partner usually contributes 1-5% of the initial’s capital. Carried interest is provided when the fund generates profits. In addition, generally, it is tied to a hurdle rate.

For instance, say fund A’s target is to gain a return of 20% after a successful exit. But in reality, it earns 17%. Then, the general partner will not receive any ‘carry’ or might get a lesser percentage or may even get eliminated as per the agreement with the fund A.

Suppose, the fund ‘A’ gains profit as expected. Then this is how the profit gets divided.

Let us assume the fund ‘A’ raised $2 bn funds. The investors or the limited partners share is $1900 million and the general partner share is $100 million. With the $2 bn capital, the group makes investments in targeted companies.

After the holding period, say 7 years, they receive a total of $10 bn. The partners first receive their capital back i.e., $2 bn. The profit $8 bn will get divided into 80:20 ratio (75:25 ration in top private equity firms). The limited partners share the net worth of profit $6.4 bn among themselves as per their investment whereas the general partner receives $1.6 bn. The $1.6 billion would get shared among senior partners and other participants as per the agreement. The general partner also receives a separate annual fee depending on the asset size.

It is to be noted that the general partner will not receive any salary as such, but the profit share. This is carried interest and gets taxed as a capital gain. Let us see the importance of carried interest.

Significance of carried interest

While investing in PE firms, private equity professionals must understand their potential to invest. They need to weigh the cost including their expertise and the potential profit a fund can bring. It could be for good or bad, a carried interest is the norm of any private equity industry.

Experienced investors may forgo an investment and choose other investment options. General partners are like entrepreneurs starting a new business and treat their return as capital, but not as a salary or wage.

Tax treatment of carried interest

The investments made by PE funds are capital assets as per existing law. The capital gain is a reward for the entrepreneurial investments of labor and capital. The share of the net gains is taxed on a ‘pass-through’ basis as a capital gain.

Taking back the carried interest

The ‘carry’ can be taken back when the fund is not performing well or underperforming. It is known as claw-back arrangements. For instance, the limited partner might have expected a return of 15% annual return, and they get only 11%. A portion of the carry paid to the general partner would be taken back.

It is a risky return on investment for the general partner. And, it is difficult to enforce clawbacks when the carry recipients had left the firm or there was a financial setback.

Ray Maxwell, a limited partner turned consultant suggests that to ensure that the general partner will not have the tilt of favor, the maximum marginal carried interest should be 50 %.

Moving forward, let us see how the carry structures are different in various parts of the world.

Carry structure across the globe

In January 2020, Maryland and the Senate have passed a bill. Accordingly, a 17% addition of state taxes will be added to the carried interest. Similar kinds of laws exist in California, Connecticut, Massachusetts, New York, New Jersey, and, Rhode Island.

Europe follows a whole-of-fund approach. here the managing partners will get their profit share after the investors get paid for their capital and returns. Many investors do not allow to take carry before the term of the fund.

In Australia, the model is somewhat similar to the European model. The limited partners are dominating in private equity. The funds having a favorable history and performance can alone negotiate carry terms.

To summarize…

Carried interest in private equity is risky and needs a lot of experience from the fund manager side to win. It is like an incentive for the decisions taken by them to invest the money and earn profits on the right ventures. Likewise, the investors assume the risk as explained by the fund managers.

Striking the right balance between the risk and reward is essential to be on the PE field.

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