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The Definitive Guide to Carried Interest: Breaking Down How Funds Are Incentivized

One of the main ways venture capitalists earn money is through carried interest (often known as carry). When managing a fund, your primary focus should be increasing carry by creating greater returns for your investors (known as limited partners).

 

If you’re a limited partner, it’s important to know how carry works to weigh an investment opportunity’s potential accurately.

 

This post examines carried interest, how it works, and why it’s important.

 

To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.

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One of the main ways venture capitalists earn money is through carried interest (often known as carry). When managing a fund, your primary focus should be increasing carry by creating greater returns for your investors (known as limited partners).

 

If you’re a limited partner, it’s important to know how carried interest works to weigh an investment opportunity’s potential accurately.

 

This post examines carried interest, how it works, and why it’s important.

What Is Carried Interest?

Carried interest is the percentage of profits that will go to the fund managers. Simply put, it is how general partners get compensated when limited partners receive profits.

 

General partners (GPs), also known as fund managers, are half of a fund’s partnership, along with limited partners (LPs).

 

General partners do the following to earn carry:

 

  • Organize the fund
  • Find other investors
  • Manage the fund
  • Raise 0% to 10% of the capital
  • Endure 100% of the risk
  • Develop a strategy
  • Make a relationship with businesses and entrepreneurs in their field
  • Maximize a fund’s value before a sale or initial public offering

 

 

How Does Carried Interest Work?

The typical interest rate charged to limited partners is 20%, although some general partners may ask for higher rates. As a matter of fact, some funds charge more than 30% carried interest based on their success rates.

 

This means that after the limited partners receive the initial investment amount, the general partners share 20% of the profit, while the limited partners keep the remaining 80%.

 

A general partner‘s carry percentage is an essential part of a fund’s partnership agreement, which all limited partners become party to when they join the fund.

 

Carried Interest Distributions

Some venture capital managers make lots of money through carried interest

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Carried interest can be described in two ways, with the first being the most common:

 

  • Whole fund (also known as European waterfall): Carry is applied all over fund-level returns.

 

  • Deal by deal (also known as American waterfall): Carry is awarded on a deal-by-deal basis.

 

Carried interest differs from the management fee a general partner collects for managing the fund (typically 2% of the fund’s commitments).

 

A typical venture usually contains around 25 companies that pay off after four to five years. Carried interest is paid on top of management fees that act as the general partner’s salary. This fee covers a general partner’s expenses as they manage the fund.

 

Even with a 5-year timeline and millions of dollars on the line, only about 25% of venture capital funds are profitable. However, some venture capital managers thrive in this business.

 

For instance, Jim Simons is valued at over $28 billion. This is because he manages Renaissance Technologies, valued at over $130 billion. Simmons gets a return average of more than 71.8%, and a management fee of 5%, and 44% carried interest.

 

Limited partners are the main investors, but they don’t manage the fund or share the profits without an extra fee. These two groups form a limited partnership.

 

Below are a few examples of limited partners:

 

  • Pension funds
  • Wealthy individuals
  • Trust funds
  • Asset management companies

 

Carry is only paid out to general partners when limited partners receive their initial investment and profits. This rate of return is often known as the hurdle rate.

 

What Is the Hurdle Rate?

Carry is never guaranteed. Even if the fund returns the limited partner’s initial investment, it must reach a set profit rate for the general partner to receive carried interest.

 

This rate is often referred to as the hurdle rate or carry hurdle. If this rate is not reached, the general partners do not receive carry.

 

Additionally, in a fund where the carry is applied on a deal-by-deal basis, limited partners can decide to “claw back” interest earned on an individual deal if the fund doesn’t meet the carry hurdle. This usually happens at the end of a fund to recover a limited partner’s potential losses.

 

How to Calculate Carried Interest

Below is an example to help you understand how carried interest works:

 

Say a limited partner invests $8000 in a fund that charges 20% carried interest. The fund has a successful exit, and the limited partner’s distribution is $100,000.

 

The general partner will receive 20% after the limited partner has deducted their principal ($100,000-$8,000).

 

In this case, the general partner earns $18,400 (20% of $92,000.) The limited partner nets the remaining $73,600 and their initial $8000 investment, which totals $81,600.

 

Why Is Carried Interest Important?

Carried interest provides an incentive for managers to take bigger risks

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There are several reasons why carried interest is important. Here are some of the main ones:

 

  • It is taxed at a capital gains rate of between 15% and 20%. Therefore, fund managers enjoy lower rates than other professionals.
  • It provides the incentive for managers to take huge risks so that they can earn higher interest. The entire private investment world operates under this principle.

 

Taxation of Carried Interest

The government takes a different approach when taxing carried interest.

 

The preferential tax treatment is especially important for a private equity fund and its managers. A typical private hedge fund uses carry to pass through profits to its general partners, who then pass it through to the investment managers.

 

The investment managers pay a federal personal income tax on these profits at a rate of 23.8% (20% tax on net capital gains and 3.8% on net investment income tax).

 

Key Restrictions of Carried Interest

Carry can be a great deal for many fund managers. Most funds put restrictions on when the fund can be paid to protect the interests of limited partners.

 

Below are some of the features the funds use:

 

  • Hurdle rate: The fund managers don’t receive carry until the fund earns the minimum agreed rate of return for limited partners. This reduces the potential loss to limited partners.

 

  • Clawbacks: If a hedge fund enjoys huge returns and pays out carry to the general partners then tanks, the general partners have to give back some of that interest.

 

  • High water mark: The fund doesn’t pay carried interest unless its investments exceed the previous mark. This protects limited partners from paying carry twice when income rises, drops, then rises again.

 

  • Vesting: Vesting arrangements pay the profits over time to the limited and general partners. This keeps both groups motivated to maximize the hedge fund’s profits.

 

The vesting schedule typically tracks the fund’s investment period. In most cases, the vesting period lasts from one to six years. Some adjustments are made to the vesting schedule to make room for the early departure of some investment professionals.

 

However, investment managers continue to receive a management fee regardless of how the hedge fund performs.

 

Why Carried Interest Is Controversial

Some believe that hedge funds take advantage of the carried interest loophole (which allows general partners to pay a net capital gains rate of 20%).

 

Many economic commentators argue that it would be fairer to tax carry like wage and salary income, which use ordinary income tax rates (subject to a top tax rate of 37%). They compare hedge fund managers to investment bankers, who pay an ordinary income tax rate on their salaries, bonuses, and wages.

 

They also note that most service providers are unable to treat their income as capital gains. Some commentators add that if we treat capital interests like wage and salary income for the general partners, we should also allow limited partners to deduct the interest as an ordinary expense.

 

On the other hand, some commentators believe that hedge fund managers are like entrepreneurs who start a new business and may treat their current interests as capital (not wage or salary) for their “sweat equity” contributions.

 

America’s tax law typically adopts the latter conversion of labor income to capital because it cannot quantify and time the contribution of sweat equity.

 

The Tax Cut and Jobs Act reduced the tax preference for carried interest by giving private equity funds a minimum three-year holding period, up from one year, to treat any gains allocated to its investment managers as long-term.

 

Any profits obtained from the sale of assets held for a period of three or fewer years would be treated as short-term. Therefore, it would be taxed at a rate of 40.8%. That said, most private equity funds hold their assets for more than five years, so the longer holding period might not affect them.

 

Why You Should Consider Using Carried Interest

Deal by deal carried interest is beneficial to fund managers

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As we’ve already established, using carried interest has several benefits.

 

Carried interest is figured differently depending on the hedge fund. For instance, deal-by-deal carried interest is a great deal for general partners. This is because normal agreements combine losses and gains to determine the bottom line for profit sharing.

 

However, deal-by-deal carried interest allows private equity managers to earn interest only on successful assets without factoring in losses. Although the investors must be paid back, a deal-by-deal carried interest is more profitable for private equity managers.

 

On the flip side, a deal-by-deal carry is bad for hedge funds. This is because the general partners tend to concentrate on winning assets and ignore the rest completely. This is common in equity and hedge funds but is new to venture capital funds. People who support this say there are only a few wins in a fund, so it’s not unfair.

 

Carried interest is also figured based on the equity in the fund. Therefore, interest is based on a limited partner’s contributions.

 

Bottom Line

Carried interest compensates private equity and hedge fund managers for good performance. Only funds that are structured as limited partnerships can pay carried interest.

 

Deal-by-deal carried interest benefits general partners because it only pays carried interest for the winning assets. On the other hand, a European waterfall considers both gains and losses when awarding carried interest.

 

Carried interest is also controversial because managers pay lower taxes for their earnings than other professionals pay as wage or salary taxes.

 

To view the fundamental guide to limited partnerships, check out this post.

 

To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.

 

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