Carried Interest in Private Equity – Definition & Explanation

FAQ

Why is carried interest so controversial?

Carried interest is controversial because it allows investment managers (PE, VC, Real Estate, Etc.) to be taxed at a lower, long-term capital gains rate on their income.

Carried interest is paid to investment managers, typically in private equity, venture capital, real estate and hedge fund investment partnerships, as a percentage of the profits they generate from the investments they oversee.

Carried interest is paid out to investment managers (general partners) after investors in a fund receive their initial investment back.

After a predetermined return threshold is met and paid to investors (limited partners), the investment manager receives a share of the remaining profits, usually around 20% for major institutional investors, which is called promote or carried interest.

What Is Carried Interest?

Carried interest serves as the performance or incentive fee within a private equity fund or another type of alternative investment, awarded to the general partners (GPs).

Private equity and other investment funds typically operate as limited partnerships, with the GP managing the fund and its investments, while the limited partners (LPs) provide capital.

GPs receive compensation through a management fee, based on a percentage of the fund’s assets, and a performance fee, typically following a performance fee structure, typically called carried interest.

This performance fee aligns GP interests with those of the investors, incentivizing them to maximize returns.

The term “carried interest” signifies the GP’s stake in the fund’s performance throughout its lifespan, accruing as assets are sold.

However, it’s typically not paid out until investors receive their initial investments back, along with a predetermined minimum return, known as the preferred return.

Once this preferred return is met, the GP can receive a portion of the performance fee as outlined in the fund’s investment agreement.

If you are looking to invest in private equity or other types of alternative investments, there are now some funds that accept capital from accredited investors.

Historically, this was an asset class that was reserved for pension funds, sovereign wealth funds and other institutional investors.

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What Is An Example of Carried Interest

In the below example, a private equity general partner (investment manager) begins with a $20 million investment from limited partners.

Over time, the fund’s investments grow the assets to $80 million, resulting in a $60 million gross return (capital gains).

The General Partner becomes eligible for carried interest after returning the Limited Partners initial investment of $20M.

Assuming a 20% share of profits above this threshold, the manager would receive a portion of the remaining profits as carried interest.

This exemplifies how carried interest incentivizes fund managers to achieve superior investment performance, aligning their interests with those of the investors.

Where Does Carried Interest Come From?

Carried interest comes from the gross proceeds of the investment returns that an alternative investment manager oversees.

In addition to taking a small percentage of the investor’s assets on an ongoing basis to cover the costs of running their business (called a management fee), their carried interest is the payoff for successfully driving a strong investment return for their limited partners and comes from the proceeds.

How Do Private Equity Firms Invest?

Private equity firms invest in companies, often using leveraged buyouts (LBOs) to amplify returns.

They identify opportunities, structure deals, and implement strategies to enhance operational efficiency and drive growth. With a typical investment horizon of 3 to 7 years, they aim to exit through options like IPOs or trade sales, realizing profits from increased company value.

Ultimately, private equity firms make money by creating value and executing strategic exits, providing returns to their investors.