Carried interest is a type of performance-based compensation paid to investment managers, private equity firms, and venture capital funds. This compensation is typically calculated as a percentage of the profits made by the fund, after the investors have received a certain return on their investment. The entities involved in carried interest include the investment fund, the fund investors, the investment manager, and the portfolio companies.
Understanding Carried Interest
Carried interest is a form of compensation often used in private equity funds. It refers to the share of profits that goes to the fund’s managers and investment professionals. Here’s an in-depth explanation of the structure:
Structure of Carried Interest
Typically, carried interest is structured as follows:
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Waterfall: A waterfall is a tiered structure that determines how profits are distributed among investors. In private equity funds, the waterfall typically allocates a certain percentage of profits to investors (known as the “hurdle rate”) before managers receive any carried interest.
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Performance Threshold: The hurdle rate is usually set at 7% or 8% of the capital invested. Once the fund’s returns exceed this threshold, managers are eligible to earn carried interest.
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Distribution Ratio: The distribution ratio determines how much of the profits are distributed as carried interest. It is typically set at 20% or 25%, but can vary based on the fund and its performance.
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Vesting Period: Carried interest is usually subject to a vesting period, which means that managers must remain employed with the fund for a certain amount of time before they can receive their share of profits.
Example of a Carried Interest Structure
Consider the following example:
| Return Scenario | Distribution to Investors | Distribution to Managers |
|---|---|---|
| 6% | 100% | 0% |
| 8% | 90% | 10% |
| 10% | 80% | 20% |
In this example, managers receive 10% of profits only after the fund’s returns exceed the hurdle rate of 8%. Once the returns reach 10%, managers are entitled to the full distribution ratio of 20%.
Timing of Carried Interest Payments
Carried interest is typically paid out once the fund has been fully liquidated. This can take several years, depending on the fund’s investment strategy and market conditions.
Question 1:
- What constitutes a carried interest?
Answer:
Carried interest is an equity share in the profits of a private equity fund or other investment vehicle that is distributed to the fund’s managers.
Question 2:
- What are the key features of a carried interest?
Answer:
Carried interest typically has a “carried interest threshold,” which is a minimum return to the investors before any distribution is made to the fund managers; and a “hurdle rate,” which is a minimum rate of return that the fund must achieve before the carried interest is paid out.
Question 3:
- How is carried interest regulated?
Answer:
Carried interest is regulated by various tax and securities laws, which may vary depending on the jurisdiction in which the fund is domiciled.
And there you have it! Now you know what a carried interest is, and you can impress your friends at the next cocktail party with your financial knowledge. Thanks for stopping by, and be sure to visit us again soon for more investing insights and financial wisdom. Cheers!