What Is Carried Interest And What Characteristics Does It Have?
Carried interest, or carry, is a financial arrangement commonly used in the investment and private equity industry. It represents a share of the profits earned by an investment fund’s managers, typically the general partners, when the fund’s investments generate positive returns. It serves as an incentive for fund managers to maximize returns for the fund’s investors, who are the limited partners.
Key characteristics include:
- Profit Sharing: It is a form of profit sharing. Fund managers receive a percentage of the fund’s profits, typically after a specified minimum return, known as the “hurdle rate,” has been achieved for the investors.
- Performance-Based: The receipt of it is contingent on the fund’s performance. It encourages fund managers to make profitable investments and enhance the fund’s overall returns.
- Percentage Share: It is usually calculated as a percentage of the fund’s profits above the hurdle rate. Common percentages range from 10% to 30%, but the exact percentage can vary depending on the fund’s specific terms and agreements.
- Alignment of Interests: It aligns the interests of fund managers with those of the investors. Since managers benefit from the fund’s success, they have a strong incentive to make prudent investment decisions.
- Long-Term Horizon: It often includes a “clawback” provision, which means that fund managers may be required to repay a portion of previously received carried interest if the fund’s overall performance deteriorates over time.
How Does Carried Interest Work?
It is typically structured as a share of the profits earned by an investment fund after a certain minimum return, known as the “hurdle rate,” has been achieved for the fund’s investors.
It is often calculated as a percentage of the fund’s profits above the hurdle rate. Fund managers receive it as an incentive for their performance in generating returns for investors.
What Does 20% Carried Interest Mean?
A 20% carried interest means that the fund manager is entitled to receive 20% of the profits generated by the investment fund after the fund has achieved the hurdle rate or a specified minimum return for investors.
This percentage represents the share of the upside profits that the fund manager can claim as their carried interest.
What Is The Difference Between Carried Interest And Performance Fees?
Carried interest and performance fees are terms that are often used interchangeably in the context of investment funds, but they can have slightly different meanings depending on the specific fund structure. Both typically refer to a share of the fund’s profits that fund managers receive for their performance.
The key difference may be in terminology and the specific terms used in a fund’s legal documents. It is more commonly associated with private equity and venture capital funds, while performance fees may be a broader term encompassing various types of investment funds.
Why Is It Called Carried Interest?
The term “carried interest” is derived from the historical practice of nautical partnerships in the 18th century. Ship captains and crew members would enter into agreements to share the profits from successful voyages. The captain’s interest, or share of the profits, was known as the “carried interest” because it was carried over and above their regular wages.
This concept was later adapted to the financial world, particularly in the private equity and investment fund industry, to describe the share of profits that fund managers receive.
