Land-based merchants would commission ships to export their merchandise to ports around the Mediterranean, with the ship’s captain and other crew members receiving an “interest” in the profits earned from the cargo that they carried.
Today, carried interest is a major component of the private equity GP compensation model colloquially known as ‘two and twenty’ – an annual management fee of 2% of committed capital and an allocation of 20% of net profits (the carried interest), which usually accrues only after the investors have received back some or all of their capital plus a preferred return.
Although 20% remains the most common carry percentage, the market has recently grown more varied and innovative:
Some fund managers have re-worked the basic carry framework to have it ratchet up or down according to performance. The objective is to reward the GP with a higher carry percentage if the fund achieves certain benchmark returns, which are often linked to net IRR or cash multiples. For example, carry is set at an initial level of 10% until the fund returns twice (‘2x’) the amount of investors’ called capital, then ratchets up to 20% until the fund returns three times (‘3x’) investors’ capital, and finally ratchets up to 30% for all returns above 3x.
There are two main ways to accrue carry:
- ‘Whole fund’ carry is calculated on the fund’s overall returns. It is generally considered safer for investors because they have absolute priority in the first two levels of the distribution waterfall (return of capital and payment of hurdle). This reduces the risk of carry being ‘overpaid’ to the manager during the course of the fund’s life. Whole fund carry is fairly standard in the European market.
- ‘Deal-by-deal’ carry is calculated on the profits of each deal, independently, at the time of divestment. It is generally thought to be manager-friendly, because the manager can avoid taking a hit on less profitable or loss-making exits, while still continuing to earn carry on more profitable deals. This allows carry to accrue much more rapidly and potentially at a higher rate than the headline carry percentage, unless and until this ‘overpaid’ carry is clawed back from the manager. Deal-by-deal carry is more common in the United States than Europe.
Hybrid carry tries to address investors’ concerns about deal-by-deal carry by augmenting it with various investor-protective features to make it behave more like whole fund carry – for instance, instituting regular clawbacks (the process of recalculating the carry entitlement, comparing it to actual carry distributions, and recouping any excess carry distributions), and escrowing a portion of carry.
Used by a number of European first-time funds, the diverted carry model is a type of hybrid carry in which deal-by-deal carry distributions are diverted to the investors until they have received amounts equal to the sum of their called capital, preferred return and undrawn capital. The investors do not have to return the diverted carry to the fund, but subsequently the manager is allowed to ‘catch up’ on the diverted distributions as and when proceeds roll in from exits. It is a neat way of integrating downside protection for investors into deal-by-deal carry.
Multi-waterfall carry allows investors to choose the type of return structure that best suits them.
For instance, Class A investors agree to pay deal-by-deal carry on returns but get a hefty discount on management fees, whereas Class B investors pay whole fund carry and are charged management fees at the full rate.
Alternatively, investors may have to choose among different mixes of hurdle rates, management fees and carry percentages – for instance, Class A investors may pay a 1% management fee and 25% carry with a 10% hard hurdle, whereas Class B investors may pay a 2% management fee and 20% carry with an 8% preferred return.
Perhaps the simplest change in the carry model is to shift the percentage rate. A handful of top-tier private equity and venture capital managers have been able to negotiate ‘super carry’. This is carry fixed at a higher percentage level than the traditional 20%. Well-known examples of super carry (for some of their funds) include Bain Capital, Accel Partners, Andreessen Horowitz, and Kleiner Perkins Caufield & Byers. All told, we have seen carried interest range from 5% to a remarkable 80%.
In 2017, Pantheon Ventures launched a new private equity fund that blends management fees and carried interest into a single performance-based fee. The fund marks its assets to market daily, with the performance fee accruing only on those days when (and by how much) it outperforms a benchmark stock market index, with the fee accrual being reversed on days when the fund underperforms the benchmark.