Carried Interest In Private Capital

A Glossary of CRE & PropTech Terms

In a typical private investment partnership, LPs provide the majority of the capital, while GPs put in less capital, but are responsible for day-to-day management of the asset or investment. To compensate for the imbalance in capital, responsibility, and risk, GPs are typically entitled to “carried interest”, in addition to their management fees. So what exactly is carried interest, and why is it such an important factor for fund/firm managers?

How Does Carried Interest Work?
Carried interest, often referred to as “carry”, represents the share of profits that the GPs of a fund receive as compensation. Specifically, the carry is an amount above and beyond the amount that GP should receive if profits were to be split in proportion to the total amount of capital invested.That means that if an LP contributes 90% of the capital, and the GP 10%, if the GP is due to receive their carry, they would receive more than 10% of the profits. Typically, the carry is only applicable after the investment has hit a certain performance hurdle.

Let’s break it down:

1. Fund Structure and Contributions: An investment fund typically consists of contributions from LPs, who provide the bulk of the capital, and GPs, who manage the fund and usually contribute a smaller portion of the capital.
2. Investment Period: The fund's capital is invested in various assets, such as startups, real estate, or other opportunities, over a predefined period.
3. Profit Generation: Over time, these investments are expected to generate returns. When an investment is sold or goes public, any profits realized are distributed according to the terms set out in the fund's agreement.
4. Return of Capital: Before the GPs can receive any carried interest, the LPs are usually entitled to a return of their initial investment, often referred to as the "return of capital."
5. Preferred Return (Hurdle Rate): In many cases, the LPs are also entitled to a preferred return, or hurdle rate, which is a minimum return on their investment before the GPs receive any carried interest. This rate is typically around 8% but can vary based on market conditions.
6. Profit Split: Once the LPs have received their return of capital and the preferred return (if applicable), the remaining profits are split between the LPs and GPs. The standard carried interest rate is 20%, meaning GPs receive 20% of the profits, and the remaining 80% goes to the LPs. This split can vary depending on the fund's agreement.

Example:

Imagine a real estate fund that raised $100 million from LPs and $5 million from GPs. Over time, the fund's investments generate $150 million in returns. Here’s how the carried interest might be calculated:

1. Return of Capital: LPs and GPs receive their initial investments back. After the return of capital, there is $45 million in profit remaining ($150 million - $105 million).
2. Preferred Return: Assuming an 8% preferred return, LPs are entitled to an additional $8 million.
3. Remaining Profits: After the return of capital and preferred return, $37 million in profits remain ($150 million - $105 million - $8 million).
4. Carried Interest: The GPs receive 20% of the $37 million, which amounts to $7.4 million. The remaining 80% or $29.6 million goes back to the LP.
   

Why It’s Important

Carried interest operates as an incentive to maximize performance and align incentives.

1. Incentive Alignment: Carried interest incentivizes GPs to maximize the fund's performance since their compensation is tied directly to the profits generated.
2. Tax Treatment: In many jurisdictions, carried interest is taxed at a lower capital gains rate rather than ordinary income, which has been a subject of debate and calls for reform.
3. Risk and Reward: While carried interest can be highly lucrative, it also comes with risk, as GPs only earn it if the fund performs well and exceeds the return of capital and preferred return thresholds.

Understanding carried interest is crucial for anyone involved in or considering investing in private equity or venture capital, as it significantly impacts the economics and incentives within these funds.

For some additional reading on how it came about in the first place, check out its History section on Wikipedia - it’s been around longer than you may think!