Explaining carried interest

‘Carried interest’ is the name given to the profit share schemes that investors in venture capital funds, typically called ‘LPs’, use to incentivise the partners at at the funds in which they invest. The partners are typically called the ‘Manager’, as their job is to manage the fund by making investments and managing the portfolio to maximise returns to LPs. We’re going through the process of explaining and awarding carry to the people in Forward Partners and I thought I’d share the explanation there.

Most Managers of venture capital funds in Europe get 20% of the profits on the entire fund once a minimum hurdle has been returned. If there is no hurdle then the maths are fairly simple. A good fund is one that returns 3x the investment made by LPs. We are aiming for a £30m fund, so in our case a 3x fund would mean we are returning £90m to our LPs with a profit of £60m. The carry pot would then be 20% of £60m, which is £12m, and that money would be shared amongst the staff and partners at the Manager according to a percentage split agreed when the fund was set up.

Similarly, if the fund returned £40m and there is no hurdle then the profit would be £10m, and the carry pot would be £2m.

If a high level understanding is sufficient for you then stop reading here. If you want to understand how hurdle rates apply to marginally profitable firms then read on.

Hurdle rates stipulate that the Manager delivers a minimum return before any carry gets paid out. That minimum return is expressed as an annual percentage increase called the hurdle rate. The table below shows the impact of a 5% hurdle in the examples above:

Screen Shot 2014-03-25 at 19.31.11

There are two things to understand here. Firstly, how the hurdle effects whether carry gets paid out, and then the secondly how the ‘cartch up’ effects the amount of carry in the pot.

  1. Line 6 shows the amount the fund would have to return to beat the hurdle and get into carry. You can see that the amount goes up each year as an extra year of the 5% hurdle compounds. Lines 7 and 8 show whether carry would pay out at all with a given level of profit in each year, illustrating the point that the hurdle only matters if a fund is marginally profitable. You can see that with a £10m profit carry will only pay out if the returns are realised by year five (which would be fast), whereas when a fund is tripled carry will payout regardless of how long it takes. Note that these calculations make the simplification that all investments are made on day one of the fund and all the returns come in one lump in the year indicated.
  2. Lines 10 and 11 show how the ‘catch up’ operates to get the Manager back to 20% of total profits after the hurdle has been reached. If the catch up is 100% then once the hurdle has been reached then all additional profits go into the carry pot until it has caught up to 20% of total profits. Most LPs want the catch up clause to be a little more favourable to them and stipulate that during the catch up phase 80% of additional profits go into the carry pot whilst the other 20% go to LPs. These catch up provisions only bite in situations where a fund is just into carry.

If you want to see the workings or play with the assumptions in the table above you can find the underlying spreadsheet here.

The final piece of the puzzle is vesting. Much like options in a startup carried interest schemes vest over time, typically five or seven years.