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What Is Carried Interest in Real Estate
Here is what you will discover by reading this article.
- You will understand how carried interest can propel your fund towards success.
- The most important legal clauses to make the investing partnership fair for everyone.
- You will have a working framework to move to the next steps.
Real Estate Carried Interest
The term "carry interest" refers to the portion of a fund's investment profits that fund managers receive as compensation. Carried interest rewards fund managers who produce exceptional investment returns. The portion of fund profits allocated as carried interest is 20%, yet this rate may change based on the specific fund type and contractual terms.
It's important to note that carried interest is not the same as the administration fee (usually 2%), which is assessed on the amount of the investor's account each month and pays for the overhead expenses for managing the fund.
Carried interest becomes payable only after the investment fund achieves returns beyond the predefined hurdle rate. For example, if the hurdle rate stands at 8%, the carried interest becomes applicable solely to profits that surpass this rate.
The real estate field uses terms like "promoted interest" or "promote" for carried interest because this bonus incentivizes fund managers to deliver superior investment returns.
The Origins of the Term - Carried Interest
It is interesting how unusual terms or sayings evolved into today's common vernacular. Here are the origins of "carried interest."
The shipping industry of the 16th-century European maritime exploration era introduced carried interest. Ship captains' compensation during this era included a 20% share of transported goods profits to cover their work efforts and the hazards faced at sea, like piracy.
The profit-sharing system encouraged ship captains and their crews to work towards successful voyages because their financial interests were aligned with those of merchants and investors.
Investment professionals adopted the term "carried interest" from the historical practice of calling profits from transportation cargo aboard ships "carried goods."
Profit-sharing between captains and merchants evolved into a modern financial model used by private equity and venture capital fund managers who receive investment profit shares to compensate for their management responsibilities and risk assumptions.
Carried Interest in Real Estate Funds - Investor Perspective
Real estate has some unique features that set it apart from other investments. One of the most significant differences is the time these investments take to pay off. Unlike some assets that might turn a profit quickly, real estate requires a longer commitment to reach its full potential.
Investors, whether they're accredited individuals, family businesses, or corporations, often hang onto their properties for over 15 years. Why? Because they see these assets as a way to build wealth that can last across generations. In the fund industry, we often hear this referred to as "patient capital." It's all about taking the time to let those investments mature!
Next, fund managers face challenges with extended time frames because carried interest becomes relevant only after exiting the investment and surpassing the hurdle rate. Some funds may assess a special financial charge known as a liquidity premium to compensate for the delay in receiving carried interest.
Nowadays, a typical practice among private equity and venture capital firms is to include a 20% carried interest clause in the limited partners agreement (LPA). But if a firm is successful and in high demand, it can increase that percentage.
Sophisticated investors are not deterred by carried interest charges. The first-in-first-out hurdle rate protects them. Returns over and above the hurdle rate are the bonus money, from which they would receive 80% of those profits.
Benefits of Carried Interest for Fund Managers
So, let's talk about carried interest and why investment managers are so passionate about defending it. Carried interest aligns managers' pay with how well their fund performs. The managers and the investors are on the same team, working toward maximum returns while taking smart risks that benefit everyone involved.
For investment firms, carrying interest is crucial to attracting and keeping the best talent. This type of compensation stands out in a competitive market where everyone wants to hire top-performing professionals.
When fund managers have this carried interest incentive, it pushes them to dig deep and find investment opportunities that could offer significant returns. This flexibility allows them to devise innovative strategies that can be quite profitable.
The interesting thing about carried interest is that fund managers only earn from it if their fund performs above a certain level—a minimum return known as the hurdle rate. This setup rewards managers who go above and beyond rather than just settling for mediocre results.
The real estate sector pushes for beneficial tax treatment of carried interest to stimulate entrepreneurial activity and innovation within its high-risk environment. Carried interest encourages entrepreneurial spirit and risk-taking, both of which are crucial for keeping startup ecosystems thriving and, in turn, boosting economic growth.
With the passage of the Tax Cuts and Jobs Act of 2017, the required holding period for carried interest to receive long-term capital gains treatment extended from one year to three years, which affected the structure of real estate investments.
How to Structure Carried Interest in Your Real Estate Fund
The following outline presents an overview of the legal clauses for creating carried interest structures within investment funds.
Fund Formation & Objectives
- Determine if the fund strategy is private equity, venture capital, real estate, or another type because these categories affect the carried interest terms.
Jurisdiction Selection
- Select a tax-efficient jurisdiction to establish the fund's legal structure (such as Delaware for U.S. funds or the Cayman Islands for offshore funds).
Capital Commitments
- Obtain binding financial commitments from limited partners (LPs) while defining the total fund amount and investment duration.
Carry Economics Design
- Establish the carried interest percentage, which generally stands at 20% but can include multi-tiered arrangements when performance exceeds expectations. Implement a hurdle rate between 8–12% IRR or a multiple of invested capital, ensuring LPs recover their capital and achieve minimum returns before receiving carry payments.
American Waterfall Distribution Model
- Allows for carried interest payments on each transaction individually while including provisions to reclaim funds if the overall fund performance falls below expectations. LPs obtain cash payments that depend on the fund's performance without owning equity stakes.
Limited Partnership Agreement (LPA)
- The Limited Partnership Agreement describes the carry mechanics and details the waterfall distribution sequence and clawback conditions.
Clawback Provisions
- General Partners must return carried interest to investors when subsequent investments do not meet performance expectations, as is standard practice in American waterfall structures.
Holdback Reserves
- Hold 20–30% of carry distributions to safeguard against future clawback obligations.
GP Catch-up
- GPs receive entire profits after surpassing the hurdle until their earnings meet the 20% share requirement.
Compliance & Tax Considerations
- Maintain a minimum holding period of three years to qualify for long-term capital gains treatment under the Tax Cuts & Jobs Act (TCJA) rules established after 2017.
Regulatory Filings
- Comply with SEC (U.S.) guidelines or applicable local laws for fund registration and disclosure requirements.
Finalization & LP Onboarding
- Gather limited partner commitments followed by verification of their understanding of carry terms.
Capital Calls
- Allocate capital based on the fund's specified investment period.
Reporting Systems
- Fund managers should use specific software tools like Carta to manage hurdle rate tracking, carried interest calculations, and distribution amounts.
Integrating these contractual agreements in the LIMITED PARTNERS AGREEMENT (LPA) balances General Partner compensation and incentives with the Limited Partner guaranteed hurdle rate and performance participation.
Pitfalls to Avoid
Creating an LPA using overly complex terms or exhaustive spreadsheet examples would be difficult for the limited partners to grasp and a confused mind would say, no.
A thin LPA that does not set clear performance benchmarks and the actions when these benchmarks are not met, such as carried interest refunds.
Failing to establish communication protocols and channels to ensure timely and transparent communication with investors.
Investor Perspective on Carried Interest
Think of carried interest as a kind of premium that investors pay to gain access to top-notch management teams—these are pros who can spot high-growth opportunities or undervalued assets that most passive investors might overlook.
Investors usually believe that carried interest aligns fund managers' objectives with their interests. With a 20% profit share, managers are motivated to focus on creating long-term value rather than pursuing short-term profits.
The LPs' first win is the fund meeting the hurdle. The second is the bonus payout, a share of the profits over and above the carried interest amount payable to the GP.
Hey, everything is great if a fund generates alpha returns. But what if the fund is experiencing average performance?
Average Performance Example
A real estate fund yields a 10% gain of $300K while implementing a 4% hurdle rate and charging a 15% carry fee. In this case, the carried interest would amount to $45K for the general partner (GP)
The investors' total profit was $255K (8.5% net return vs. 10% gross). The 1.5% deduction from investor returns caused by the carried interest demonstrates the impact of carried interest on average-performing investments.
Performance Deficits Protection (Claw Back)
A silver lining for investors is that if there is a clawback clause in the LPA, they can reclaim any previously distributed carry payments to help compensate for performance deficits. If a fund only realizes a 5% return, missing the 8% hurdle in the Limited Partnership Agreement (LPA), the clawback can help balance things out.
Summary
Mastering carried interest is essential for anyone looking to launch and manage a successful real estate fund. Understanding how carried interest works can significantly influence the alignment between fund managers and their investors, ultimately driving better performance and long-term value. Fund managers can optimize returns for themselves and their investors by effectively managing the intricacies of carried interest, ensuring everyone benefits from a successful investment.
Our Fund Launch Black Card Membership becomes an invaluable resource for aspiring fund managers; Fund Launch offers the expertise and support needed to navigate the complexities of carried interest and fund management. We provide the tools and knowledge to help you build a robust LPA structure, including understanding hurdle rates, clawback provisions, and incentive alignment. With our guidance, you can develop strategies that attract investors and sustain long-term growth and prosperity.
In today's competitive landscape, understanding and strategically implementing carried interest can be the differentiator that sets your fund apart. With Fund Launch by your side, you can confidently move forward, knowing you have the resources to achieve your goals and build a thriving real estate fund.
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