How to Calculate Carried Interest

Carried interest represents a share of the profits of an investment fund, paid to the fund’s manager, known as the General Partner (GP). This compensation is performance-based, aligning the interests of the fund manager with those of the investors, or Limited Partners (LPs). It incentivizes General Partners to generate returns on capital committed by Limited Partners in private equity, venture capital, and hedge funds.

Key Elements of Carried Interest Calculation

Committed capital refers to the total amount of money that Limited Partners formally agree to invest in a fund over its lifespan. Capital contributions, often called drawdowns, are the actual funds requested from Limited Partners over time as the General Partner identifies investment opportunities. These are the cash amounts actively deployed into portfolio companies.

Distributions represent the cash or assets returned to Limited Partners from successful investments or exits. A preferred return, also known as a hurdle rate, specifies a minimum rate of return that Limited Partners must receive on their invested capital before the General Partner can begin to earn carried interest. This rate is typically between 7% and 10% for private equity funds and is usually cumulative and compounded annually.

Management fees are ongoing charges paid by Limited Partners to the General Partner, typically ranging from 1.5% to 2.5% annually of committed capital or assets under management. These fees cover the fund’s operational expenses, such as salaries and administrative costs, and are separate from carried interest. A catch-up clause is a provision that allows the General Partner to receive a larger share of profits after the preferred return is met, enabling them to “catch up” to their full carried interest percentage. For instance, the General Partner might receive 50% to 100% of subsequent distributions until their share aligns with the agreed-upon carried interest.

Net invested capital represents the portion of the Limited Partners’ contributed capital that has not yet been returned to them. It is calculated by subtracting all distributions of capital from the total capital contributions.

Common Carried Interest Distribution Models

The methodologies used to distribute profits within a fund are often referred to as “waterfalls” due to their tiered structure. These contractual agreements dictate the priority of distributions between Limited Partners and General Partners.

The deal-by-deal waterfall, also known as the American waterfall, calculates and distributes carried interest on a per-deal basis. Under this model, as each individual investment is successfully exited, proceeds are first used to return the capital invested in that specific deal to the Limited Partners, followed by the preferred return. After these conditions are met, remaining profits from that specific deal may trigger the General Partner’s catch-up clause, followed by the carried interest split. This structure allows General Partners to receive carried interest earlier, but it often necessitates clawback provisions if later deals underperform.

In contrast, the fund-as-a-whole waterfall, or European waterfall, calculates carried interest only after the entire fund’s contributed capital and aggregate preferred return have been returned to the Limited Partners. The typical tiers involve returning all contributed capital to Limited Partners, then providing the preferred return, followed by the catch-up clause, and finally the carried interest split. This approach is more favorable to Limited Partners as it reduces the need for clawbacks, since the General Partner’s profit share is deferred until overall fund profitability is confirmed.

Variations of these primary models also exist, often combining elements to create hybrid structures tailored to specific strategies. For instance, a fund might use a deal-by-deal approach for initial distributions but then switch to a fund-as-a-whole calculation after certain thresholds are met. These customized waterfalls balance incentives for General Partners with protection for Limited Partners.

Practical Calculation Examples

Consider a deal-by-deal (American) waterfall scenario for a private equity fund. Assume an investment of $50 million in Company A, with an 8% preferred return and a 20% carried interest for the General Partner, subject to a 50% catch-up provision. Company A is sold for $80 million, generating a $30 million profit.

First, the Limited Partners receive their invested capital of $50 million. Next, the preferred return on the $50 million investment is calculated. Assuming the investment was held for one year, the preferred return is $50 million multiplied by 8%, equaling $4 million.

The remaining profit is $80 million (sale price) minus $50 million (capital return) minus $4 million (preferred return), which leaves $26 million. With a 50% catch-up clause, the General Partner receives 50% of this $26 million, which is $13 million, until their total profit share reaches their 20% target. Once the General Partner has “caught up,” the remaining $13 million is distributed according to the 80/20 split, with Limited Partners receiving 80% ($10.4 million) and the General Partner receiving 20% ($2.6 million). In this example, the General Partner’s total carried interest from Company A is $13 million plus $2.6 million, totaling $15.6 million.

Now, consider a fund-as-a-whole (European) waterfall example for an entire fund with $200 million in committed capital, an 8% preferred return, and a 20% carried interest for the General Partner, with a 100% catch-up. Over the fund’s life, Limited Partners contribute $180 million in capital, and total distributions from all successful exits amount to $300 million.

First, the Limited Partners receive the full return of their $180 million contributed capital. Next, the preferred return on the $180 million contributed capital must be satisfied. Assuming the average holding period and preferred return calculation results in a cumulative preferred return of $20 million, the Limited Partners receive this amount.

At this point, $180 million (capital) + $20 million (preferred return) = $200 million has been distributed to Limited Partners. The remaining $100 million from the total $300 million distributions is profit.

With a 100% catch-up, the General Partner receives 100% of the next distributions until their share of the total profit reaches 20%. The General Partner’s target carried interest is 20% of $100 million, or $20 million. The General Partner receives the first $20 million of the remaining $100 million. After the General Partner has “caught up” to their 20% share, the remaining $80 million is distributed 80% to Limited Partners ($64 million) and 20% to the General Partner ($16 million). In this fund-as-a-whole example, the General Partner’s total carried interest is $20 million plus $16 million, equaling $36 million.