Formulae: Carried interest is the share of the fund's profits earned by a GP after it has returned a fund's capital to its investors, usually after payment of a preferred return (effectively an interest rate) on the average balance of commitments outstanding before the capital is repaid. For almost all funds, the rate of carried interest is 20 percent of the fund's profits. Most funds' terms include mechanisms to allow a GP to 'catch up' (see fuller discussion below) on its 20 percent share of distributed profits if a fund succeeds in producing gains larger than those necessary to pay back the original capital plus the preferred return. Assuming a fund 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 fund is extremely profitable and/or if the committed capital of the fund is large and produces substantial profits in absolute terms, even if the preferred return threshold is narrowly exceeded.
As an example, if a fund has committed capital of €2 billion, and over time generates proceeds of €3 billion, or 1.5x committed capital, 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 fund'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.
Given that the number of senior to middle-ranking employees at a private equity firm 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 funds are the vehicles of capital gain in question. This quantum of potential individual profit reward concentrates private equity fund managers' minds and can lead to exceptional discipline, focus, and result-orientation in identifying, managing, and exiting compelling investments. In addition, the fact that both LPs and GPs 'win' when a fund 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 capital gains.
Nuances: Although the 20 percent of profits to the GP formula is typical of private equity funds, some firms with particularly successful track records (especially sought-after Silicon Valley venture capital firms raising relatively small funds) in the past agreed with their LPs a higher carried interest rate of 25 percent or even 30 percent to the GP. The GPs in question then argued that such a higher rate was merited because they chose to raise a smaller capital base, and therefore to generate lower management fees and forego incremental capital gains in absolute terms, than they might otherwise have given LPs demand for the type of exposure and potential exceptional gains their fund offered. LPs consented to this diminished share of the gains on these funds either because this was the price of admission for a massively oversubscribed fund offered by a top-tier firm with an exceptional history and market position, or because they expected the profits from the fund to be so substantial in absolute terms that they would still be satisfied with a smaller piece of the pie, or both.
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 capital or buyout firms has yet to rebound to the stratospheric levels that previously justified premium terms. As such, for now, departures from the 20 percent carried interest norm are now rare. What constitutes a 'return of capital' 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 fund's operation were significantly weaker than they are today. Often funds allowed 'deal-by-deal' carried interest terms and calculations, without reference to LPs' total capital commitments to a fund. Under these terms, a GP became entitled to carried interest on individual deals when they were exited profitably and returned their pro rata capital contributions and the associated preferred returns to LPs. The risk for LPs under these arrangements was that not all deals would be profitable, leading to their absorbing capital 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 fund's original terms.
Unsurprisingly, after experiencing some cases of over-distribution in funds 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 fund' carried interest computations. This required the repayment of all capital 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 fund had to repay the capital invested in both loss-making or written-down investments and profitable ones, as well as the 'accrued interest' on that invested capital.
These provisions protected LPs in over-distribution scenarios, but were themselves subject to nuances. For example, did GPs have to repay all the original capital committed to a fund, 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 fund turned profitable from exited investments? Generally speaking, most funds now operate with 'whole fund' provisions and with the 'drawn-down capital' interpretation of them, but the tougher, 'all committed capital' standard has at times been imposed by LPs on startup, unproven funds or on those groups with mixed track records and therefore less negotiating leverage in setting the terms of the fund.
In the post-GFC world, unsurprisingly those firms and funds 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 fund ones - came under that pressure to move to the mainstream. 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 fund approach are now rare.