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Carried Interest in Private Equity: What It Is and How It Works.
Upon reading this article, you will discover how a properly structured private equity fund creates a win-win arrangement between the General Partner (GP) and the Limited Partners (LPs). Also, you will understand how a GP can realize tremendous profits after the fund exceeds certain thresholds.
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We are fund launch experts and have worked hand-in-hand with individuals like yourself to create over 300 funds in the last three years. The most popular fund types are hedge funds, private equity, venture capital, and real estate.
Definition of Carried Interest
The share of profits from an investment or investment fund, known as carried interest, serves as incentive compensation for the General Partner who oversees the fund. A GP earns carried interest only when the fund generates returns surpassing the predetermined hurdle rate or preferred return; for example, 8% per year is quite common.
Incentivizing General Partner Performance
Carried interest exists mainly to motivate fund managers to increase investor returns. The GP's financial interest through carried interest connects their earnings to the fund's performance, which drives them to choose investments that will produce superior returns.
The standard rate for carried interest is usually 20% of a fund's net profits, but it can change based on the fund's specific strategy, negotiation outcomes, and prevailing market conditions.
- The general partner receives 20% of surplus profits when fund profits exceed the hurdle rate.
- The LPs receive 80% of all profits after the General Partner takes their share.
General Partner Additional Compensation
Annual Management Fee
The GP receives an annual payment from the LPs, representing 2% of AUM. This fee covers the GP's operating expenses, including salaries, office costs, research, and other overhead costs.
Carried Interest in Practice
The fund generates carried interest when liquidating its investments through IPOs, acquisitions, or secondary sales. GPs do not receive compensation until the fund achieves a minimum return threshold, usually between 6 and 8% per year.
Fund managers obtain their carried interest payments based on the fund's profitability and distribution regulations.
Here are two different distribution models.
American-style waterfall (deal-by-deal)
General Partners can receive carried interest from successful individual investments even when other deals in the fund fail to meet performance targets. Investment losses remain separate from gains unless clawback provisions become active.
European-style waterfall (portfolio-level)
The fund must first return all LPs their initial capital and hurdle rate before making any carried interest payments.
Hypothetical Example
For a $100M fund with a 20% carry and 8% hurdle rate, the LPs receive $108M before profit distribution, which comprises their initial $100M plus the 8% hurdle rate.
The remaining $32M will be divided between the Limited and General Partners. Of the total distribution, $25.6 million (80%) will be allocated to Limited Partners, and $6.4 million (20%) will be allocated to the General Partner.
Hurdle Rate and Carried Interest - Reputational Impacts
Positive Performance
When fund managers deliver successful carried interest payouts, this demonstrates strong financial performance, drawing attention from prospective investors. A Private equity firm that achieves $20M in carried interest from $100M profits demonstrates enhanced market credibility with its 20% share.
Risk of Underperformance
When returns drop below the hurdle rate of 8%, the GP earns no carried interest, negatively impacting the fund’s reputation and ability to raise more capital.
Tax Implications of Carried Interest
Fund managers benefit from a lower tax rate because carried interest gets taxed as long-term capital gains instead of ordinary income. Carried interest receives favorable tax treatment because it is considered an allocation of investment earnings that resembles investor returns instead of fees for services provided.
Under the Tax Cuts and Jobs Act of 2017, the underlying assets must be held for over three years to be eligible for long-term capital gains tax rates, which increased the holding period requirement from one year. This condition allows carried interest to be taxed at the maximum federal rate of 20% with an additional 3.8% net investment income tax instead of facing the highest ordinary income tax rate of 37%.
Proponents of this tax treatment believe that because fund managers assume investment risk and pay depends on fund performance, carried interest should qualify as investment income. Opponents believe carried interest functions as performance-based compensation, which merits taxation as ordinary income instead of capital gains.
Carried interest receives long-term capital gains tax treatment at reduced rates compared to ordinary income for fund investments held over three years, which is typical in private equity and venture capital.
Comparing Carried Interest in Private Equity vs. Other Funds
The payment structures for carried interest in private equity and real estate funds vary based on their unique structures and risk profiles.
Carried interest in private equity funds is allocated according to each investment through the American-style waterfall. Once a profitable investment matures, the GP receives carried interest immediately from it, following the repayment of invested capital and preferred returns to LPs for that particular investment.
Investment losses are separate from these gains unless a clawback provision activates them. GPs can receive their profit share from individual successful deals before the entire fund has fully returned capital to investors.
Real estate funds typically employ a European-style waterfall structure, in which carried interest payments commence only after investors recover their initial capital, along with the agreed-upon preferred return across the entire fund.
The GP receives its share of the profits from the remaining pool only after meeting the hurdle rate thresholds. The GP's carried interest becomes available later in the investment cycle. It is typically collected after the sale of the fund's final assets so that LPs receive full compensation before GPs gain from the fund's profitability.
The structural difference creates alignment between the incentives and risk-sharing of GPs and LPs for each asset class. Private equity funds offer the possibility of carry payouts before completing an entire fund cycle, while real estate funds mandate complete fund-level performance before distributing carry payments.
Carried Interest Versus Promoted Interest - Similar but Different
The payment structures for the GP incentive in private equity and real estate funds vary based on their unique structures and risk profiles.
Carried interest in private equity funds is allocated according to each investment through the American-style waterfall. Once a profitable investment matures, the GP receives carried interest immediately from it, following the repayment of invested capital and preferred returns to LPs for that particular investment.
Investment losses are separate from these gains unless a clawback provision activates them. GPs can receive their profit share from individual successful deals before the entire fund has fully returned capital to investors.
Promoted interest in Real estate funds typically employs a European-style waterfall structure. In this structure, payments commence after investors recover their initial capital and the agreed-upon preferred return across the entire fund.
The GP receives their share of the profits from the remaining pool only after meeting the necessary thresholds. The GP's carried interest becomes available later in the investment cycle. It is typically collected after the sale of the fund's final assets so that LPs receive full compensation before GPs gain from the fund's profitability.
The structural difference creates alignment between the incentives and risk-sharing of GPs and LPs for each asset class. Private equity funds offer the possibility of carry payouts before completing an entire fund cycle, while real estate funds mandate complete fund-level performance before distributing carry payments.
To Recap the Main Points
Definition and Purpose:
Carried interest is the share of profits from an investment or investment fund that serves as incentive compensation for the General Partner (GP) who oversees the fund. Its primary purpose is to motivate fund managers to increase investor returns by connecting their earnings to the fund's performance, driving them to choose investments that produce superior returns.
Calculation and Structure:
A GP earns carried interest only when the fund generates returns surpassing a predetermined hurdle rate or preferred return, commonly around 8% per year. When profits exceed the hurdle rate, the standard rate for carried interest is typically 20% of a fund’s net profits. After the GP takes its share, the remaining 80% of surplus profits go to the Limited Partners (LPs). GPs also receive an annual management fee, usually 2% of Assets Under Management (AUM), to cover operating expenses.
Comparison with Other Funds:
While structures vary, carried interest in private equity funds differs from promoted interest in real estate funds mainly in its distribution timing due to the waterfall structure. Private equity (American-style) allows potential carry payouts earlier, deal-by-deal, while real estate (European-style) requires full fund-level performance and capital return before GPs receive their share. This difference impacts the alignment of incentives and risk-sharing.
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