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One of the main ways venture capitalists get paid is through carried interest (often referred to as “carry”). If you’re managing a fund, your goal should be to maximize your carry by earning great returns for your investors (known as limited partners or “LPs”). If you're an LP, it pays to understand carry so that you can properly weigh the potential of an investment opportunity.
Let’s look at how carried interest works, how it’s calculated, and what implications it has for both fund managers (known as general partners or “GPs”) and their LPs.
Carried interest represents the percentage of profits that will go to the fund manager. It’s how a GP gets compensated when LPs see a return on their investment.
The typical carried interest rate charged to LPs is 20%—although some GPs can command higher rates. This means that after the LPs are repaid their original investment amount, the GPs will receive 20% of the profits from the fund, while the remaining 80% of profits are paid to the LPs. A GP’s carried interest percentage is a key component of a fund’s partnership agreement, which all LPs become party to when they join the fund.
When distributions are paid out, the GP is generally paid carried interest once 100% of the contributed capital is paid back to the LPs. The profit made from the fund determines how much carry the GP earns.
Carried interest can be defined in one of two ways, with the first being the most common in venture:
Carried interest is separate from the management fees the GP collects for managing the fund (which are typically 2% of the fund’s commitments).
Carried interest is never guaranteed. Even after the fund returns the LPs' principal, it must exceed an agreed upon rate of return. This rate of return is often referred to as the "carry hurdle" or "hurdle rate." If the rate is not achieved, the GP does not receive carry.
Further, in a fund where carry is applied on a deal-by-deal basis, LPs can "claw back" carried interest earned on an individual deal if the fund doesn't meet the agreed upon rate of return. This usually occurs at the end of a fund to make up for LPs' potential losses.
To understand carried interest, it helps to look at an example.
Say an LP invests $5k in a fund that charges 20% carried interest. The fund has a successful exit, and that LP’s distribution is worth $100k. The GP will receive 20% of the amount the investor earned after their principal is paid back ($100k - $5k = $95k).
In this case, the GP earns $19k (20% x $95k). The investor nets the $76k in profits plus their initial investment of $5k, which comes out to $81k.
As of June 2021, carried interest is generally taxed as long-term capital gains based on the GP’s tax bracket. In order to qualify for the long-term capital gains tax rate, the GP must have held the assets generating the carried interest for a minimum of three years. Depending on the context, carried interest may also qualify for QSBS treatment.
For GPs, carried interest provides an economic incentive for them to help their investments succeed. For LPs, it’s the price they pay for access to profitable investments.
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