Formulae: Carried interest is the share of the profits earned by a GP after it has returned a fund's investment to its investors, usually after payment of a preferred return (effectively an interest rate) on the average balance of commitments outstanding before the investment is repaid. For almost all investment vehicles, the rate of carried interest is 20 percent of the profits. Most structures include mechanisms to allow a GP to 'catch up' (see fuller discussion below) on its 20 percent share of distributed profits if a structure succeeds in producing gains larger than those necessary to pay back the original investment plus the preferred return.
Assuming a structure produces sufficient gains from investments to exceed the preferred return threshold, the GP has a free and clear entitlement to 20 percent of the overall gains. This entitlement can translate into significant sums if the venture is extremely profitable and/or if the committed investment of the venture is large and produces substantial profits in absolute terms, even if the preferred return threshold is narrowly exceeded.
Example: Illustrating the Power of Carried Interest
As an example, if a structure has committed funding of €2 billion, and over time generates proceeds of €3 billion, or 1.5x committed funding, by private equity industry standards it would not be judged a huge winner. However, even if holding periods of individual investments were long, and therefore the compounded preferred return on drawn-down investments was high, the €1 billion in the structure's net profits would likely be more than sufficient to cover the accumulated preferred return. Therefore, after the catch-up mechanisms had run their course, the GP would be entitled to 20 percent of the net profits, or €200 million.
It's important to note that the tax treatment of carried interest can vary significantly depending on the jurisdiction. In some cases, carried interest is taxed as ordinary income, while in others it may be eligible for more favorable capital gains tax rates. This can have a significant impact on the after-tax returns generated for both GPs and LPs.
The Impact of Carried Interest on Individual Finances
Given that the number of senior to middle-ranking employees at a private equity company is often not large (more junior, less proven, and potentially transient employees are typically not entitled to carried interest rewards), as the example above demonstrates, the impact of carried interest distributions on individuals' personal finances and net worths can be substantial. This is true even when relatively small private equity structures are the vehicles of value gain in question. This quantum of potential individual profit reward concentrates private equity managers' minds and can lead to exceptional discipline, focus, and result-orientation in identifying, managing, and exiting compelling investments. However, this potential for large payouts has also drawn scrutiny, with some critics arguing that it incentivizes excessive risk-taking.
In addition, the fact that both LPs and GPs 'win' when a structure succeeds, and split the profits 80/20, leads to an alignment of their financial goals and interests, with each constituency well-rewarded when investments generate meaningful value gains. This alignment of interests is often cited as a key strength of the private equity model.
Nuances in Carried Interest Structures: From Deal-by-Deal to Whole Fund Calculations
Although the 20 percent of profits to the GP formula is typical of private equity structures, some firms with particularly successful track records (especially sought-after Silicon Valley venture companies raising relatively small structures) in the past agreed with their LPs a higher carried interest rate of 25 percent or even 30 percent to the GP. This higher rate reflected the perceived scarcity value offered by these firms.
The GPs in question then argued that such a higher rate was merited because they chose to raise a smaller funding base, and therefore to generate lower management fees and forego incremental gains in absolute terms, than they might otherwise have given LPs demand for the type of exposure and potential exceptional gains their offering offered. LPs consented to this diminished share of the gains on these structures either because this was the price of admission for a massively oversubscribed offering offered by a top-tier firm with an exceptional history and market position, or because they expected the profits from the structure to be so substantial in absolute terms that they would still be satisfied with a smaller piece of the pie, or both.
The Impact of the Global Financial Crisis and the Rise of Whole Fund Structures
However, the severe market reversals of 2008-09 damaged virtually all private equity firms' performance and track records. Although markets have since recovered, generally even the performance of ultra-blue chip, premium venture companies or buyout firms has yet to rebound to the stratospheric levels that previously justified premium terms. The crisis highlighted the risks associated with private equity investments and led to greater scrutiny of fee structures. As such, for now, departures from the 20 percent carried interest norm are now rare.
What constitutes a 'return of investment' to LPs before a GP becomes entitled to its carried interest has also changed markedly over the years. In the industry's early days, the terms governing this aspect of a structure's operation were significantly weaker than they are today. This evolution of terms reflects the growing sophistication of both GPs and LPs. Often structures allowed 'deal-by-deal' carried interest terms and calculations, without reference to LPs' total investment to a structure. Under these terms, a GP became entitled to carried interest on individual deals when they were exited profitably and returned their pro rata contributions and the associated preferred returns to LPs. However, this approach created potential for misaligned incentives.
The risk for LPs under these arrangements was that not all deals would be profitable, leading to their absorbing losses on weak or failed deals, without any compensating make-up of these losses before the GP received its profits on successful ones. Such a scenario could result in an 'over-distribution' of profits to the GP, or an allocation of profits higher than the 20 percent intended under the structure's original terms. This mismatch led to the development of more equitable carried interest structures.
Protecting LP Interests: The Shift Towards "Fund as a Whole" Calculations
Unsurprisingly, after experiencing some cases of over-distribution in structures with these ill-crafted terms and varying performance in the underlying portfolio (often described colloquially by LPs, in respect of the GP's profit interest, as 'heads I win, tails you lose'), LPs moved to more carefully define the circumstances in which GPs could earn carried interest. These efforts resulted in 'fund as a whole' or 'whole structure' carried interest computations. This required the repayment of all contributions on all deals, whether winners or losers, as well as the associated preferred return, before GPs became entitled to carried interest. In other words, before the GP received any profits, the structure had to repay the investment invested in both loss-making or written-down investments and profitable ones, as well as the 'accrued interest' on that invested amount. This shift towards whole fund calculations aimed to provide LPs with greater protection and ensure a fairer distribution of profits.
These provisions protected LPs in over-distribution scenarios, but were themselves subject to nuances. For example, did GPs have to repay all the original investment committed to a structure, even if it had yet to be invested in transactions, or just the amount drawn down to finance fees and investments at the point at which the structure turned profitable from exited investments? These nuances highlight the complexity of carried interest calculations and the importance of clear and comprehensive fund agreements. Generally speaking, most structures now operate with 'whole structure' provisions and with the 'drawn-down investment' interpretation of them, but the tougher, 'all committed investment' standard has at times been imposed by LPs on startup, unproven structures or on those groups with mixed track records and therefore less negotiating leverage in setting the terms of the structure.
The Post-GFC Landscape: Standardization and Continued Evolution
In the post-GFC world, unsurprisingly those firms and structures that had persisted with deal-by-deal carried interest structures (generally US-based ones) - despite the preexisting market pressures to alter them to the more LP-protective whole structure ones - came under that pressure to move to the mainstream. The GFC served as a catalyst for greater standardization and transparency in carried interest structures. This is because LPs are now far more forthright about withholding their commitments and stalling legal processes until they achieve such amendments than in the past. As such, departures from the whole structure approach are now rare.
However, the carried interest remains a complex and evolving aspect of private equity investing. As the industry continues to grow and mature, we can expect further refinements and adjustments to these structures to ensure fair alignment between the interests of GPs and LPs.
