Carried interest

Carried interest is a central remuneration mechanism in the private equity world. It is a form of performance-based incentive, aligning the interests of management teams (General Partners - GPs) with those of investors (Limited Partners - LPs). Carried interest generally represents 20% of the capital gains generated by the fund, and is only paid out if a certain level of profitability is achieved.

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Definition of Carried Interest

Carried interest is a variable remuneration paid to fund managers, based on the performance of the investment fund. It is neither a fixed salary nor a commission, but a share of profits earned, granted only if a predefined break-even point (known as the hurdle rate) is exceeded.

This incentive mechanism aims to :

• Reward superior financial performance.
  
  
• Promoting long-term value creation.
  
  
• Ensure alignment of interests between GPs and LPs.

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Why is Carried Interest used in Private Equity?

Carried interest is based on fundamental principles specific to equity investments:

• Alignment of interests: GPs only receive a share of profits if investors first obtain a sufficient return on their capital.
  
  
• Performance incentive: In the absence of earnings, no carried interest is paid.
  
  
• Merit-based compensation: Only outperforming funds generate such compensation for managers.
  
  

How Carried Interest works

Carried interest is based on a clearly defined earnings distribution structure, generally organized in several stages.

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Classic distribution diagram

1. Capital repayment: Investors are entitled to full repayment of their invested capital.
   
   
2. Hurdle rate achieved: A minimum rate of return (often around 8% annual) must be achieved before any payment is made.
   
   
3. Capital gains sharing :
   
   
   
   • 80% of additional gains for investors.
     
     
   • 20% for management teams in the form of carried interest.
     
     

Calculation example

• Capital raised: €100 M
  
  
• Final fund value after 10 years: €200m
  
  
• Gross capital gain: €100 million
  
  
• Hurdle rate: 8%.
  
  

Step 1:
LPs recover €100M + guaranteed return.
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Step 2:
The surplus is distributed :

• 80% for LPs
  
  
• 20% for GPs (carried interest)
  
  

Carried Interest conditions and challenges

Hurdle rate: a performance prerequisite

The hurdle rate is a minimum rate of return required before carried interest can be triggered. It provides protection for investors. On average, the hurdle rate is between 7 and 8% a year, but it can be negotiated according to the fund's strategy and profile.

Clawback: an adjustment mechanism

To avoid situations where GPs receive undue remuneration in the event of final underperformance, a clawback clause can be incorporated. This requires managers to repay all or part of the carried interest received if the fund's final results do not meet expectations.

Example: If the fund achieves excellent performance on the first disposals but suffers losses on the last, the GPs will have to return part of the carried interest already paid.

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Taxation of Carried Interest

The tax treatment of carried interest varies from one jurisdiction to another. In France, this mechanism can, under certain conditions, benefit from a favorable tax regime. In particular, this presupposes that managers take a significant economic risk, through a personal financial commitment to the fund.

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Conclusion

Carried interest is a fundamental driver of performance and attractiveness for private equity funds. It is a powerful motivator for management teams, while offering a guarantee of reliability for investors. By regulating the distribution of capital gains, this mechanism helps to establish a lasting relationship of trust between all stakeholders.

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