What Is a Promote in Private Equity?

Private equity involves specialized investment funds that acquire and manage companies to increase their value before selling them for a profit. These firms raise capital from institutional and accredited investors, deploying it into privately held businesses or taking public companies private. Private equity firms are compensated through a mechanism known as the “promote.” This performance-based compensation aligns the interests of investment managers with their investors, directly linking their financial success to the fund’s returns.

Understanding the Promote

The “promote,” often called “carried interest,” is a share of profits paid to the fund’s General Partners (GPs). This compensation differs from annual management fees, which are typically 1.5% to 2% of assets under management and cover operational costs. Unlike management fees, the promote is a performance-based incentive, paid only if the fund achieves specific profit thresholds.

The promote’s purpose is to incentivize the investment team to maximize returns for Limited Partners (LPs), the fund’s investors. It ensures fund managers are financially aligned with investors, driving them to enhance portfolio company value and generate capital gains.

Calculating and Distributing the Promote

The promote’s calculation and distribution follow a structured process outlined in the fund’s legal agreements. This process begins with a “hurdle rate,” or “preferred return,” which is the minimum return Limited Partners must receive before General Partners are eligible for any promote. This rate commonly ranges from 6% to 10% annually. If fund returns fall below this, all profits go to Limited Partners, and GPs receive no promote.

Once the hurdle rate is met, a “catch-up” clause often applies. This provision allows General Partners to receive a disproportionately larger share of subsequent profits, often 100% of distributions, until they “catch up” to their agreed-upon percentage of total profits exceeding the hurdle. These distributions are governed by a “waterfall” distribution model, which outlines the tiered sequence for allocating capital gains.

Under a typical waterfall, the first tier returns Limited Partners’ initial invested capital. Next, Limited Partners receive their preferred return. After these conditions, the catch-up clause allows General Partners to receive a larger share of profits until their target percentage is achieved. Remaining profits are then split, commonly 80% to Limited Partners and 20% to General Partners, though other ratios like 70/30 or 60/40 can occur.

In the United States, carried interest is generally treated as long-term capital gains for federal income tax purposes, rather than ordinary income. This means promote earnings are typically subject to a lower tax rate, often 20% to 23.8% (including net investment income tax), compared to ordinary income tax rates up to 37%. To qualify, assets must be held for over three years. Carried interest is also not subject to self-employment taxes.

Promote Beneficiaries and Their Roles

The promote is paid to the General Partners (GPs) of the private equity fund. While the fund is the legal entity, the financial benefits are distributed among senior professionals within the firm. This includes partners, managing directors, and other key investment team members instrumental in the fund’s investment decisions and value creation.

The firm’s internal compensation structure determines the promote’s allocation among these individuals. Factors considered include seniority, direct contribution to successful investments, and overall impact on fund performance. Tying personal compensation to fund profitability aligns key personnel’s financial interests with investment success and Limited Partner returns.

The Promote’s Role in Private Equity Dynamics

The promote underpins the private equity business model, aligning the objectives of all parties. This performance-based compensation links General Partners’ financial success to the fund’s ability to generate substantial returns for Limited Partners. It incentivizes GPs to make sound investment decisions, manage portfolio companies to enhance value, and achieve profitable exits.

The potential for significant performance-based earnings also attracts top talent to private equity. Professionals are drawn by the opportunity for compensation tied to their success in identifying, acquiring, and growing companies. This fosters a performance-driven culture where maximizing fund returns is central. The promote serves as an incentive and a core part of the financial relationship between fund managers and investors.