Carried interest explained

The short version

A fee for running the fund, a share of the profit for running it well

A private fund’s manager (the GP) is paid in two ways. The management fee is a yearly charge that pays to run the manager: salaries, offices, deal teams. Carried interest, or carry, is the GP’s share of the fund’s profits, paid only once investors (the LPs) have got their money back, and usually a minimum return on top.

In Callan’s study of 413 private equity fund documents, the median management fee in the investment period was 1.75 to 2.00 per cent, and the vast majority of funds charged 20 per cent carry. Of those funds, 84 per cent had an 8 per cent preferred return, mostly compounded.

“Two per cent of what?”

The headline rate matters less than the base it is charged on. In one common schedule, the fee is charged on each LP’s commitment during the investment period (often about five years), then on net invested capital (money still in companies) afterwards. Callan found fees after the investment period were 20 to 25 basis points lower.

Over a fund’s life it adds up. Metrick and Yasuda put median lifetime management fees at 12 per cent of committed capital for buyout funds and 17.75 per cent for venture funds.

Most funds also offset the fee: transaction or monitoring fees the GP charges portfolio companies reduce the management fee. Every fund in Callan’s dataset had an offset, and the vast majority offset 100 per cent.

“Twenty per cent of what?” The waterfall

Carry is paid through a distribution waterfall, a set of steps that decides who gets each dollar the fund returns:

1. Return of capital. LPs get back what they paid in, fees included.
2. Preferred return (the hurdle). LPs get a minimum return, typically 8 per cent a year.
3. Catch-up. The GP receives most or all of the next distributions until it has 20 per cent of the profit paid so far.
4. The split. Everything after that is shared 80/20.

A hurdle is a floor, not a discount. With a full catch-up, a profitable fund still pays the GP 20 per cent of all profit. The hurdle only bites in the middle: Metrick and Yasuda show that if profits are at or below the hurdle, all of them go to LPs.

Whole fund or deal by deal?

In a whole-fund (“European”) waterfall, LPs get back all their capital across the fund, plus the preferred return, before any carry. In a deal-by-deal (“American”) waterfall, carry can be paid as each investment is sold, so the GP is paid earlier. In Callan’s data, deal-by-deal waterfalls were far more common; Weil’s summary of the ILPA Principles notes that the LP association calls the whole-fund version best practice while recognising deal-by-deal as a common alternative.

Paying early raises a question: what if later deals lose money? The answer is the clawback, the GP’s duty to return carry it turns out not to have earned. A clawback is only as good as what stands behind it, which is why LPs ask for an escrow of carry (the ILPA Principles suggest 30 per cent, according to Osborne Clarke and Dechert) and personal guarantees from the people who received it.

Regulators focus on disclosure rather than levels. The SEC’s investor site tells investors to be vigilant about fees and expenses, and Hong Kong’s SFC code says a fund manager should disclose the basis and amount of its fees and that they should be fair and reasonable.

Questions LPs ask about fees and carry

1. What is the fee charged on in each period: commitments, invested capital or NAV? When does it step down?
2. What share of portfolio-company fees is offset against the management fee?
3. Is the waterfall whole-fund or deal-by-deal, and is the preferred return compounded?
4. How fast is the catch-up, and what does the GP earn in a middling outcome, not just a great one?
5. When is carry paid, how much is held in escrow, and who guarantees the clawback?

Education only. This page explains how fund structures and terms generally work. It is not investment, legal or tax advice and is not a view on any fund, manager or product. Worked examples are hypothetical.