Carried Interest: How Fund Managers Profit from Performance

This article provides an overview of how Carried Interest works, its role in fund compensation, and outlines the essential terms to know. While there are different distribution models, this article primarily focuses on the European waterfall structure, as it is widely used in private equity and venture capital.

What is Carried Interest?

Carried Interest, known as "Carry," is a performance-based share of a fund’s profits allocated to General Partners (GPs). It serves as an incentive for fund managers to generate strong returns while ensuring that Limited Partners (LPs) receive a predefined level of returns. Typically, GPs receive 20% of the total profits, but only after LPs have met a specified return threshold, known as the hurdle rate.

In most funds, LPs are also entitled to a Preferred Return (e.g., 8% annually), which must be achieved before Carry is distributed. This ensures that LPs receive a minimum return on their investment before profit-sharing begins.

How Carry is Distributed (European Waterfall Focus)

Carry follows a distribution model known as the "waterfall," which dictates how fund profits are shared between LPs and GPs. The two primary approaches are:

European Waterfall

• LPs receive their committed capital and hurdle rate returns before any Carry is distributed, ensuring that investor interests come first.

• LPs are often entitled to a Preferred Return before Carry is allocated to GPs.

• This structure prioritizes investor returns and is often referred to as the "investor-friendly model.
  

American Waterfall (Comparison Only)

• GPs receive Carry after each successful exit, rather than waiting until the fund’s overall performance is assessed.

• Allows GPs to access Carry sooner in the fund lifecycle.

• Profits from early exits may be distributed as Carry, even if later investments underperform, leading to uneven profit distribution risk.

• LPs can recover overpaid Carry if overall fund returns fall short through clawback provisions.

• This structure benefits GPs and is often referred to as the "GP-friendly model.

Clawback Provisions: Ensuring Fair Compensation

A clawback provision ensures that GPs do not receive more Carry than they are entitled to. If early distributions result in an overpayment, the excess amount must be returned.

• Fund performance is evaluated at the end of the investment period or at predefined checkpoints.

• If GPs have received more than their fair share of Carry, they must return the excess, which is then redistributed to LPs.

• This protects LPs from premature or disproportionate payouts.

Hurdle Rate and Catch-Up Phase

The hurdle rate is the minimum return that must be achieved before GPs are eligible to receive Carry. Once the hurdle rate is met, the catch-up phase begins:

• During this phase, GPs receive all capital distributions until they have reached their agreed percentage of Carry.

• After the catch-up phase, remaining profits are split based on the standard Carry percentage - usually 80% to LPs and 20% to GPs.