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What is carry?

“Carry”, short for “carried interest”, is a fundamental concept in the world of private equity (PE). It refers to the share of the profits that a private equity fund manager/General Partner (GP) is entitled to receive once investments are sold and certain predefined return thresholds are met. This is in addition to the management fees that the GP typically receives.

The standard carry percentage in the industry has historically been around 20%, meaning that the GP would be entitled to 20% of the profits, while the remaining 80% would go to the investors/ Limited Partners (LPs). However, the GP only starts to receive this percentage once the LPs have achieved a specific return on their investment, commonly known as the “hurdle rate”. This rate is often set around 8% but can vary based on negotiations and the specifics of the fund.

Using the above as a framework, lets look at a €100,000 investment with a holding period of 5 years and a total return of 15%p.a. over 5 years.

Future value (after return of 15% p.a. over 5 years, net of fees and costs): €201,135.70

LP Investment plus preferred return (LP entitled to first 8% p.a.) = (€146,932.80)

The profit in excess of LP investment plus preferred return) = €54,202.90

So, the Carried interest (profits above the investment + preferred return) = €54,202.90

The GP share (20% of the carried interest) = €10,840.58

LP share (80% of the carried interest) = €43,262.32

Total received by GP = €10,840.58

Total received by LP = €146,932.8 + €43,262.32 = €190,195.12

So, of the €101,135.70 value (i.e. €201,135.70 less €100,000.00 investment) created in the above example, the LP retains:  €90,195.12 (i.e. 89.2%) and the GP is rewarded: €10,840.58 (i.e. 10.8%)

Why is carry important?

Carry serves as a performance incentive for the GP. By aligning the interests of the GP with those of the LPs, carry ensures that the GP is motivated to generate meaningful returns on investments. If the investments underperform and the hurdle rate is not met, the GP will not receive any carry.

5 things investors should look out for?

Hurdle Rate: As mentioned, the GP only starts receiving carry once a certain return threshold (the hurdle rate) is met. Investors should understand what this rate is and whether it’s cumulative or non-cumulative. A cumulative hurdle means the GP can only receive carry if the overall fund returns exceed the hurdle rate, while a non-cumulative hurdle applies to individual investments.

Waterfall Structure: This refers to the order in which profits are distributed between the LPs and the GP. The most common structures are “European” and “American”. In a European waterfall, the carry is calculated on the overall fund proceeds (so good investments will net off bad ones). In an American waterfall, the carry is calculated on each individual investment.

Catch-Up Provisions: Some agreements include a provision where, after the LPs have received their original investment plus the preferred return (based on the hurdle rate), the GP can “catch up”. Catch up clauses can vary but typically this results in the GP receiving all the remaining profits to a threshold. For example the GP can receive all the remaining proceeds till the amount equals 20% of the LPs’ distribution (original investment + preferred return). Having reached this threshold any remaining proceeds are then split 80/20 LP/GP. This can significantly impact the distribution of profits.

Clawback Provisions: This is a protective measure for investors. If a GP has received carry from earlier successful investments but later investments perform poorly, a clawback provision requires the GP to return some of the previously received carry to ensure the agreed profit split is maintained.

Transparency and Reporting: Investors should ensure that the fund provides regular, detailed reports on performance, allowing them to monitor whether the carry is being calculated and distributed correctly.

It is important to remember that while carry is a standard feature in private equity, its specifics can vary widely between funds. It’s crucial for investors to understand these details and their implications to make informed investment decisions.

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