How Does Carried Interest Work Step-by-Step

carried interest

TL;DR

Carried interest, often simply referred to as “carry,” is a share of the profits that fund managers (general partners) receive as compensation for their role in managing a venture capital or private equity fund.

Unlike traditional management fees, which are fixed, carried interest is performance-based. This means that GPs only earn carried interest if the investments generate profits beyond a certain threshold, ensuring that their compensation is directly tied to the fund’s success.

How Does Carried Interest Work?

The mechanics of carried interest can be understood through a step-by-step breakdown:

  1. Capital Commitment: Investors, known as limited partners (LPs), commit a certain amount of capital to a fund. The GPs then use this capital to invest in various startups or companies.
  2. Hurdle Rate: Most funds include a hurdle rate, which is the minimum rate of return that the fund must achieve before GPs are entitled to receive carried interest. This rate is typically set at around 8%, ensuring that LPs receive a preferred return on their investment before profits are shared.
  3. Profit Sharing: Once the hurdle rate is met, the profits are divided between the LPs and GPs according to the agreed-upon carry percentage, which is usually around 20%. This means that after LPs have received their initial investment back plus the hurdle rate, the GPs receive 20% of any additional profits, with the remaining 80% going to the LPs.

Example of Carried Interest in Action

Let’s consider a simplified example to illustrate how carried interest works:

  • Total Capital Committed by LPs: $100 million
  • Hurdle Rate: 8%
  • Carry Percentage: 20%

Scenario: The Fund Generates a $140 Million Return

  1. Initial Return to LPs: The LPs must first receive their $100 million investment back, plus an 8% preferred return, which amounts to $8 million. This totals $108 million.
  2. Remaining Profits: After meeting the hurdle rate, $140 million – $108 million = $32 million in profits remain.
  3. Carried Interest Distribution: The GPs receive 20% of the remaining $32 million, which equals $6.4 million. The LPs receive the remaining $25.6 million.

Conclusion

Carried interest is a cornerstone of compensation in venture capital and private equity, designed to incentivize fund managers to deliver superior returns.

Interested in learning more VC related terms? Head over to our VC glossary!