The Fundamentals of Carried Interest

How do the managers of private pools of capital structure profits distributions with their investors?

[Edit: a few readers kindly pointed out that the math calculation in the example below was incorrect. Given my computational neural pathways are largely dormant, I am not surprised. It has been fixed to the best of my abilities. I may need accountant intervention.]

I need to apologize for the absurdly long time you have had to wait for me to get today’s topic.

It is probably the most important, controversial, and intensely negotiated term in the governing documents of a private fund. And the reason why these funds exist.

The title of this Substack has also been inspired by it.

Let’s dig into it, shall we?

Conceptual Framework

At the core, carried interest is simply the distribution of profits earned from the sale of a business owned by a private fund. This distribution is between the fund manager and the investors from whom that fund manager raised money.

The fund manager’s proposition to its investor base—when it went out and raised capital—was that it had the capabilities to manage that investor base’s capital in a way that the investors themselves could not. And generate returns on that capital through capabilities, wherewithal, or intuition (whatever magical thingamajig you want to call it) the investors lacked.

Initial stories of absurd returns in the coastal enclaves of late 20^th century America—such as Don Valentine (Venture Capital: Sequoia), Jim Simons (Hedge: Renaissance Technologies), and Henry Kravis (Private Equity: KKR)—have driven three distinct but ultimately complementary qualities that directly or indirectly reference carried interest:

Allure (“I wanna be like them”).

Contempt (“One person should never have that much money”).

Mystique (“Damn, how did they do that?”).

Beyond the facticity of these three qualities, one could merely guess at what drives the hubbub around carried interest.

Perhaps it is something fundamental: is it surprising to us that money à la carried interest is the primary incentive here?

Indeed, there seems to be little else common to successful investment management businesses.

It could be that the fund manager was formerly a healthcare executive and knew how to properly diligence drug discovery processes, device manufacturers, or lab technology.

Or traded commodities at a larger, more established fund manager.

Perhaps a maverick college graduate, an irritating yet optimistic Gen Z rebel, used his disdain for conventional marketing to convince a group of investors (his granny and two rich uncles) that he knew how to bet on new era ecommerce SaaS.

I don’t know. The origin stories of fund managers—while on the one hand ostensibly indebted to a baseline commitment to nebulous traits like “hard work” or “persistence”—often deviate from stated normative accounts of achievement in a way that obliterates the possibility that there was a standard criterion for success in the first place.

And yet, the persistence of a largely enigmatic profits arrangement reflects the enduring qualities of carried interest’s appeal across the sectoral, generational, and asset-based differences of private fund founders.

A mix of an entrepreneurial spirit, tax law, and innovative legal and financial structuring in the United States have made this achievable, in a way that has been almost impossible to replicate elsewhere.

The Technical Story

So how exactly does carried interest work?

We talk about it in the form of a “waterfall.”

Anytime an industry expert or insider speaks of chopping up the profits, it is really a reference to the “distribution waterfall”—the way a fund manager divides the money upon the sale of a fund’s portfolio investment(s).

The waterfall distribution in the limited partnership agreement (LPA) usually follows something like this:

1. Return of Capital: the initial step involves returning the original investment to LPs. This includes the principal amount invested and any management fees paid.

2. Preferred Return: most private equity funds offer a “preferred return” on the total investment, often around 8%, which LPs receive before GPs participate in profit sharing. This mechanism acts as a hurdle rate, ensuring a minimum return for investors and motivating GPs to exceed this threshold.

It’s important to note that VC funds often structure differently from PE funds. Many VC funds omit the preferred return stage, moving directly from return of capital to the GP/LP split. This arrangement reflects the higher risk profile and potential for outsized returns in venture investing, allowing GPs to participate in profits earlier and incentivizing higher-risk, higher-reward investment strategies.

3. GP Catch-Up: once the preferred return is met, many funds implement a GP catch-up. This allows GPs to receive a larger portion of subsequent profits until they reach their agreed-upon share, typically 20% of total profits.

4. GP/LP Split: after the catch-up, remaining profits are split between GPs and LPs, often in an 80/20 ratio favoring the LPs. This final stage represents the ongoing profit-sharing arrangement for the fund’s duration.

An Example

Let’s make a few, basic assumptions:

• Fund Size: $100 million

• GP Investment (1%): $1 million

• LP Investment (99%): $99 million

• Preferred Return: 8%

• Carried Interest: 20%

• Total Profit: $50 million

• Fund Final Value (initial capital + total profit): $150 million

Now, let’s break down the distribution process step by step:

1. Return of Capital:

   • LPs get back: $99 million

   • GP gets back: $1 million

2. Preferred Return (8% of LP investment):

   • LPs receive: $99 million × 8% = $7.92 million

   • Total profit: $50 million

   • Minus preferred return: $7.92 million

   • Remaining: $42.08 million

3. Catch-up (GP gets 100% until they have 20% of distributed profits above the preferred return):

   • 20% of $7.92 million = $1.584 million

   • GP receives: $1.584 million

4. Carried Interest Split (80/20 on remaining profits):

   • Remaining after catch-up: $42.08 million - $1.584 million = $40.496 million

   • LP share (80%): $32.3968 million

   • GP share (20%): $8.0992 million

Final Distribution:

• LPs receive: $99 million + $7.92 million + $32.3968 million = $139.3168 million

• GP receives: $1 million + $1.584 million + $8.0992 million = $10.6832 million

Look a little more closely at the final payout amounts.

Then compare it to what the LPs and the GP put into the fund in the first instance.

Wild.

Doesn’t always happen. But when it does, the payouts break the Richter scale.

A sample illustration from iCapital, a financial technology company that operates in the private markets:

And then there are the tax-advantages: if a GP defers its receipt of its share of the carried interest by a certain amount of time, the tax characteristic of that income changes such that it is taxed at a lower rate.

The amount saved can be enormous—a discussion for another time.

One final note.

This isn’t how all waterfalls are structured. There are many variations.

The one mentioned above is a “European” style waterfall. Sometimes referred to as a “whole fund” structure.

Contrast this with the “American” style waterfall, also called a “deal-by-deal” structure.

In the deal-by-deal structure, fund managers can earn carried interest from individual profitable investments, even if the fund hasn’t returned all capital to investors. This allows managers to reap rewards sooner, especially if an early investment is highly profitable. However, it carries risks for LPs because if later investments perform poorly, they might not see full returns on their original capital before managers take their share.

The whole fund structure is more conservative. Managers only receive carried interest after investors are fully repaid their initial capital and any preferred return. This approach protects investors by ensuring they get their money back before managers do. It also helps align the interests of managers with the overall performance of the fund rather than short-term gains from a few early successes. It reduces the risk of managers benefiting from early, high-return deals, while later bad investments may erode the fund’s performance.

This stuff gets vastly more complicated, but I hope this made enough sense for you to get a grip on what is most important.

See ya when I see ya!