Carried interest, known as carry, is an incentive compensation that’s provided to private equity fund managers to ensure their interests are aligned with the capital-providing investors of the fund. Carry is a percentage of the fund’s profits and is rewarded to fund managers on top of their management fees and plays a big role in private equity compensation. On average, carry is around 20% of the fund’s profits and can range up to as high as 50% in exceptional cases or as low as below 10% of the fund’s profits.

As there’s increasing competition from various firms to attract investments and outperform each other, there’s increasing downward pressure on carry. This general concept applies across the industry but it’s important to highlight that many different carry structures have varying complexity. Firms with good investment history have better carry structures, while newly-opened firms are often at a disadvantage.

Given its growth potential and propensity for discounted valuations during new fund establishment, carried interest PE-wise can be a powerful financial planning tool and as well as a compelling asset.

To make things clearer, below we offer a carried interest guide for private equity professionals looking to make the most of this powerful asset.

Carried Interest Factors

Carried interest is the share of any profits received by the general partner of private equity and hedge funds. It refers to the general partner being carried by investors since it gets a share in profits disproportionate to its capital commitment to the fund.

Fund managers get carry and a management fee which is justified by industry executives because each investment requires plenty of work to generate a profit. Fund managers tend to do a lot of due diligence before investing as they invest significant capital, mainly to acquire majority ownership.

Afterward, fund managers get seriously involved in strategy, business development, financial management, and restructuring. They focus on turning a company back to profitability, restructuring it to generate higher returns, or unlocking hidden value through a liquidity event such as an IPO, acquisition, or recapitalization.

Generally speaking, carry is vested anywhere from one year to six years in rare cases, and 3-4 years being the average. Luckily for investors, a higher title within the company doesn’t result in a shorter vesting period and investors usually prefer a multi-year vesting period to keep fund managers concentrated on long-term profitability.

Equity-Based Carry

Equity-based carry is the traditional concept of carry ever since private equity firms came about. Interest in a fund is allocated as shares based on each Limited Partner’s capital contribution, with a certain percentage of these shares allocated as carry to the General Partner.

Typically carry shares have a multi-year vesting period that follows investments made. Equity carry is usually split between senior executives at the private equity firm. Do remember that carried interest has many flavors and that comparing apples to apples of two different carry packages is hard.

Hurdle Rates

When the fund generates profit above a certain hurdle rate, the General Partner receives carry. The hurdle rate can be described as a particular internal rate of return (IRR), an annualized and compounded return rate that Limited Partners must receive before the General Partner gets carried interest profits.

A Limited Partner may invest in, for instance, an equity index that generates a 6% annual return. Limited Partners, by investing in a private equity fund, take on higher-than-market risk and want a minimum rate of return (hurdle rate) before sharing the profits with the General Partner.

Floors

Certain funds are structured with a “floor” where carried interest is solely allocated on investments where net profits exceed the hurdle rate. There’s no “catch-up” provision for the General Partner and unsurprisingly General Partners fiercely resist this.

Who Keeps Carry?

In reality, a small number of private equity teams receive full dibs on their carry. Oftentimes, retired partners get a carry share for a certain period after they retire as part of the buyout of their equity in a firm. A share of 10% to 50% of carry to their old or existing owners is paid by private equity firms that are spun out, have minority shareholders, or are owned by a parent company.

Escrow and Claw-Back

Most investors demand escrow and “claw-back” arrangements so early over-payments are returned if the fund doesn’t perform as a whole. However, claw-backs are hard to enforce if carry recipients have left the firm or experienced major financial setbacks like investing their carry in shares that collapsed.

Final Thoughts

Carried interest is a vital concept in the private equity field, with huge potential to grow your compensation and rewards. While it varies between funds and firms, it’s crucial to know how it works to ensure your compensation is fair.