How Exactly Does Private Equity Carry Work?

Private equity firms operate by pooling capital from various investors to acquire and manage companies or other assets. These firms, known as General Partners (GPs), aim to generate substantial returns for their investors, the Limited Partners (LPs). A fundamental aspect of how GPs are compensated for their efforts and success is through a mechanism called “carry,” or carried interest. This performance-based compensation aligns the interests of the fund managers with those of the investors.

Understanding Private Equity Carry

Private equity carry represents the General Partner’s (GP) share of profits from a fund’s investments. It incentivizes GPs to maximize returns for Limited Partners (LPs), ensuring GPs are rewarded only when LPs achieve a favorable return.

GPs manage the private equity fund, identifying investment opportunities and making decisions. LPs are the investors providing most of the capital, including pension funds, endowments, sovereign wealth funds, and high-net-worth individuals.

A fundamental premise of carried interest is that GPs only begin to receive their share of profits after LPs have recouped their initial invested capital. Often, LPs must also achieve a predetermined minimum rate of return on their investment before any carry is distributed to the GPs. This structure prioritizes the return of capital and a baseline profit for the LPs before the GPs participate in the upside.

The Distribution Waterfall Explained

The distribution waterfall outlines the sequence in which cash proceeds from a private equity fund’s investments are allocated between Limited Partners and General Partners. This process ensures conditions are met before profits are shared, providing a clear framework for returns and carried interest distribution.

The first step in any distribution waterfall is the “Return of Capital” to Limited Partners. In this tier, 100% of the fund’s proceeds are distributed directly to the LPs until they have received an amount equal to their total capital contributions, including any fees and expenses paid. This ensures that the LPs recover their initial investment before any profits are considered.

Following the return of capital, the “Preferred Return” tier activates. LPs continue to receive 100% of the fund’s proceeds until they achieve a specified annual rate of return on their capital. This preferred return, typically 7% to 10% annually, acts as a minimum threshold the fund must meet before GPs can earn carried interest.

Once the preferred return has been satisfied, the “Catch-up” phase begins. During this stage, 100% of the subsequent profits are directed to the General Partners. This allows the GPs to “catch up” and receive a percentage of the profits that brings their total share of the fund’s profits in line with their agreed-upon carried interest percentage, which is commonly 20% of total profits.

After the catch-up is complete, the final tier, “Carried Interest Distribution,” takes effect. In this stage, all remaining profits are split between LPs and GPs according to their agreed-upon proportions. Typically, this split means LPs receive 80% of the remaining profits, and GPs receive 20% as their carried interest.

Key Concepts in Carry Calculation

Beyond the distribution waterfall, several concepts define how carried interest is calculated and managed within private equity funds. These terms provide important details about financial arrangements and investor protections, clarifying the conditions under which GPs receive performance compensation.

The “Hurdle Rate,” also known as the Preferred Return, is a minimum rate of return that a private equity fund must achieve for its Limited Partners before the General Partners can receive any carried interest. This rate, often between 7% and 8% annually, ensures that investors realize a baseline profit on their capital before the fund managers participate in the upside. The hurdle rate is usually calculated using the Internal Rate of Return (IRR) or a multiple of the initial investment, as specified in the fund’s offering documents.

“Clawback provisions” are contractual terms designed to protect Limited Partners. A clawback requires General Partners to return previously distributed carried interest if, by the fund’s termination, the GPs have received more than their entitled share of the overall profits. This mechanism ensures that GPs are only compensated based on the fund’s long-term performance, even if early successful deals led to premature distributions. Clawback obligations are typically tested at or near the end of a fund’s life, ensuring the fund’s aggregate performance justifies all carry paid.

Private equity funds typically employ one of two models for calculating carry: “Fund-as-a-Whole” (or European style) or “Deal-by-Deal” (or American style) carry. Under a fund-as-a-whole model, GPs do not receive carried interest until LPs have received back all their committed capital and often a preferred return across the entire fund’s investments. In contrast, a deal-by-deal model allows GPs to earn carried interest on each individual profitable investment as it is realized, even if the overall fund has not yet returned all capital to LPs. The fund-as-a-whole approach is generally considered more favorable to LPs as it defers GP compensation until overall fund profitability is clear.

Taxation of Private Equity Carry

The tax treatment of private equity carried interest is a significant aspect of its financial structure, particularly for fund managers. In the United States, carried interest is generally taxed as long-term capital gains, rather than as ordinary income. This distinction is important because long-term capital gains typically have lower tax rates than ordinary income for individual taxpayers.

To qualify for this favorable long-term capital gains treatment, specific holding period requirements must be met. Under Section 1061 of the Internal Revenue Code, the holding period for carried interest to be treated as long-term capital gain was extended from one year to three years. This three-year holding period applies to individuals performing services in capital-related businesses.

If the holding period requirement for assets underlying the carried interest is not met, the gain is recharacterized as short-term capital gain, taxed at ordinary income rates. The IRS provides guidance on Section 1061, including exceptions. Holding periods are important in determining the effective tax rate on carried interest.