What is Carried Interest in Private Equity?
Carried interest, also known as “carry,” is the share of the profit earned by a Private equity fund or fund manager on the exit of investment done by the fund. It is the most important of total remuneration earned by the Fund manager.
It can be on a deal basis that is earned on every deal or a whole fund basis. Generally, the split in profits among the limited partners, the investors, and the general partner that is the fund manager is 80:20.
Remember, Carried Interest in private equity is not earned automatically. It will be earned by a fund manager only when the profits of a fund exceed a specified return. This specified return is known as the Hurdle rateHurdle RateThe hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment required by the manager or investor. It is also known as the company’s required rate of return or target rate.. If the fund manager is unable to achieve the hurdle rate, it won’t be entitled to receive any carried interest.
Carried Interest Example
Assuming a Private equity fund is having a carried interest of 20 % for the fund manager and a hurdle rate of 10 %. When a PE Fund realizes the profits, then these profits shall be first allocated to the limited partner that is Investors. This process shall be repeated until the time these profits reach a cumulative IRR of 10%. This 10% shall be calculated on the capital amounts that have been contributed by the investors. Any profits over and above 10% shall be split between the General Partner & Limited Partner using a ratio of 20% for the General Partner and the remaining 80% for the Limited Partner.
How do Carried Interest works?
To understand the calculations of Carried interest in private equity, let’s take another example. Suppose a PE firm, ABC Capital partners, have raised $ 1 bn funds from Investors & General partners. In this fund, Investors have contributed $950 million, and the Manager or general partner contributed $50 million.
- So 95% was contributed by Limited partners and 5% by General Partner. After receiving the capital, GP then goes ahead and makes investments in various target companies to earn profits.
- After 5 years, the GP exit all investments and receives a total of $2.5 billion. In this scenario, Limited partners would get $1bn first as that would be the capital returned.
- The remaining $1.5 bn shall be divided between LP and GP in the 80:20 ratio. So the LPs would get $1.2 bn, and $0.3 bn would go to GP.
- So GP earned 5x (250/50) on investing $50 mn.
Now, remember that not all profits go to GP. The profits are divided among senior partners who get a bigger pie while the remaining is distributed among partners and others.
Carried Interest Accounting
Let’s now understand how Carried interest is treated in books of accounts. Under the provisions of Income-tax, carried interest in private equity shall be classified as capital gains. They would be taxed at the capital gain tax rate. It is a favorable rate compared to the ordinary tax rate. Most of the critics are of the view that carry should be charged at ordinary tax rate; however, this is counter-argued with the point that any increased tax would suppress the incentive of the GP to take such high risk and invest in target companies to earn profits for LP.
There are two different views for understanding carry. They are -:
- Carry being considered as profit that is transferred from investor to manager. – Here, the focus is on the Legal form of the arrangement
- It is seen only as a performance fee of the General partner – Here, the focus is on the substance of arrangements.
The accounting treatment would be based on the view adopted for Carried Interest. Most firms continue to account for this on a cash basisAccount For This On A Cash BasisCash Basis Accounting is an accounting method in which all the company's revenues are accounted for only when there is an actual cash receipt, and all the expenses are recognized when they are paid. Small companies and individuals generally follow this accounting method. as a distribution. At the same time, other private equity funds would account for it on an accrual basis. When such interest is accounted for accrual, then the carried interest balance needs to be adjusted subsequent to the realization of investments made as well as the revaluation of investments made.
Carried Interest under IFRS
Under IFRS, various accounting standards would have to be considered. Firstly, you should determine it a -:
- A liability or
- A distribution
The standards to be considered are -:
- IAS 32 – Financial instruments – Under this, the fund manager is considered as a service provider and not as the only owner. So it is treated as per the liability model and not as per the distribution model.
- IAS 37 – Provisions, contingent liabilities, and contingent AssetsContingent AssetsA contingent asset is a potential and possible asset of the company in the future based on any contingent event beyond the company's control. It will be recorded in the balance only if it becomes certain that the economic benefit will flow to the company. – Under this, as per the agreement entered into, carried interest is treated on an accrual basis and recorded in each financial year. In this case, deal by deal, waterfall provision is applied wherein the hurdle rate is calculated for each deal. Here the fund has an obligation for each year.
Sometimes, such interest is settled by way of equity instead of cash. In this scenario, the transaction shall be treated as per the provisions of IFRS 2 – “Share-based Payment.” For the purpose of accounting, the Private equity fund shall measure the compensation payable at the fair value of the services received, and a corresponding entry shall be made into equity. Overall the impact would be a dilution of equity attributable to Limited partners, and no liability shall be created on the fund.
Carried interest in Private Equity is an incentive for a General partnerGeneral PartnerA general partner (GP) refers to the private equity firm responsible for managing a private equity fund. The private equity firm acts as a GP, and the external investors are limited partners (LPs). for the decisions taken by them to successfully deploy the money and earn handsome profits on Limited partner’s money. It is earned by a fund manager only when the profits of a fund exceed the hurdle rate.
Carried Interest in Private Equity Video
This article has been a guide to What is Carried Interests in Private Equity? Here we discuss carried interest calculation examples along with its accounting. You may learn more about Private Equity from the following articles –