2.3 Fees and carried interest

Private equity managers are paid in two ways: a steady management fee, and a share of the profits called carried interest. Together they shape the manager's incentives, reduce the LPs' net returns, and create some of the most detailed calculations in fund operations.

If you work in fund accounting, you may calculate fees and run the distribution waterfall. If you work in investor relations or on the LP side, you will explain or check those numbers. This lesson covers the main terms and works through a simple illustrative example using the course's fictional fund, Ashcombe Capital Fund I.

Every fund's terms are set in its limited partnership agreement (LPA). The figures below are common examples, not rules; terms vary between funds.

Management fees

The management fee is an annual charge paid by the fund to the manager's management company. It covers the cost of running the firm: salaries, offices, travel and the work of finding and overseeing deals. It is usually called from LPs as part of capital calls, which is why lesson 2.2's called capital included fees.

The fee typically changes over the fund's life:

The following example is illustrative. Ashcombe Capital Fund I has $100m of commitments and charges 2% a year during a five-year investment period:

• Annual fee: 2% × $100m = $2m
• Over the investment period: $2m × 5 = $10m

After year 5, the fee would fall under whichever post-investment-period basis the LPA sets.

Two other points are worth knowing:

• Fund expenses such as audit, legal and administration costs are commonly charged to the fund on top of the management fee. The LPA defines which costs the fund bears and which the manager pays from its fee.
• Fee offsets. Managers sometimes earn fees from portfolio companies, such as transaction or monitoring fees. Many LPAs require some or all of these to be offset against the management fee, so LPs are not charged twice.

Carried interest and the hurdle

Carried interest (or carry) is the GP's share of the fund's profits. It is commonly 20%, though terms vary. Carry is the main reward for performance: the team earns it only if the fund makes money for LPs.

Most funds pay carry only once LPs have earned a minimum return, called the hurdle or preferred return. The hurdle is commonly 8% a year, typically compounded on LPs' contributed capital from when it was called until it is returned. Because it depends on the timing of cash flows, the preferred return owed has to be calculated from the fund's actual dates.

Once the hurdle is met, many funds include a catch-up. For a period, most or all distributions go to the GP until it has received its full carry percentage of the profits distributed so far. With a full catch-up (100% to the GP), the GP ends up with the same 20% of total profits as if there had been no hurdle, provided the fund does well enough. Some funds use a partial catch-up, for example with 80% going to the GP, which reaches the same point more slowly.

A worked whole-fund waterfall

A distribution waterfall is the order in which the fund's proceeds are split between LPs and the GP. In a whole-fund (or "European") waterfall, LPs get back all their contributed capital, plus the preferred return, before the GP receives any carry.

The following example is illustrative and simplified. To keep the numbers round, it uses a simpler version of Ashcombe Capital Fund I than lesson 2.2:

• LPs contributed $100m in total.
• The fund eventually distributes $180m.
• The preferred return owed at 8% comes to $40m. This figure is given here; in practice it depends on when capital was called and returned.
• Carry is 20%, with a full catch-up.

Checking the catch-up: after step 2, LPs have received $40m of profit. The GP needs 20% of all profit distributed so far, including its own catch-up. If the GP receives $10m, total profit distributed is $40m + $10m = $50m, and 20% × $50m = $10m. So the catch-up is $10m.

Checking the result: total profit is $180m − $100m = $80m. The GP received $16m, and $16m ÷ $80m = 20%. LPs received $164m, or $64m of profit, which is the other 80%.

If the fund had done worse, the waterfall would stop earlier. For example, if it distributed only $130m, LPs would receive all of it (their $100m back plus $30m toward the preferred return) and the GP would receive no carry.

In practice, the waterfall is run each time the fund makes a distribution, using cumulative figures, and the GP's own commitment is usually treated like an LP's. These details are left out here.

Because so much money depends on these steps, the calculation is checked carefully. The fund's accountants or administrator usually run the waterfall, and auditors review it. Many LPs, or advisers working for them, rebuild the numbers themselves from the LPA and their capital account statements, which lesson 4.3 covers. Small differences in how a term is read, such as when the preferred return starts to accrue, can change the result.

Deal-by-deal waterfalls

In a deal-by-deal (or "American") waterfall, carry is worked out on each investment as it is sold, rather than on the fund as a whole. Typically, LPs get back the capital for that deal (and often for any deals already written off), plus a preferred return, and the GP then takes carry on that deal's profit.

The main difference is timing. The GP can receive carry earlier, from the first successful exits, before anyone knows how the whole fund will turn out. That creates a risk: if later deals lose money, the GP may end up with more than its agreed share of total profits.

Funds using this structure usually protect LPs in two ways:

• Clawback: a promise by the GP to return carry that proves to be too much once the fund's final results are known.
• Escrow or holdbacks: part of the carry is held back rather than paid out, so money is available if a clawback is needed.

Whole-fund waterfalls can also include a clawback, but it matters less, because the GP only receives carry after LPs have been repaid.

Key terms

• Management fee: An annual fee paid by the fund to the management company, commonly based on commitments during the investment period and on a lower rate or invested capital afterwards.
• Invested capital: Money the fund still has invested in portfolio companies.
• Fee offset: A reduction in the management fee for fees the manager earns from portfolio companies.
• Carried interest (carry): The GP's share of the fund's profits, commonly 20%.
• Hurdle (preferred return): The minimum return, commonly 8% a year, LPs receive before the GP earns carry.
• Catch-up: A step in the waterfall that gives most or all distributions to the GP until it has its full carry share of profits.
• Distribution waterfall: The order in which fund proceeds are split between LPs and the GP.
• Whole-fund (European) waterfall: A waterfall where LPs get back all contributed capital and the preferred return before any carry is paid.
• Deal-by-deal (American) waterfall: A waterfall where carry is calculated and can be paid on each investment as it is sold.
• Clawback: The GP's obligation to return carry that proves to be more than its agreed share.

Key takeaways

• Management fees are commonly charged on commitments during the investment period, then at a lower rate or on invested capital; illustratively, 2% on $100m for five years is $10m.
• Carry is commonly 20% of profits, usually paid only after LPs receive a preferred return, commonly 8%.
• A full catch-up lets the GP reach its full 20% share of profits once the hurdle is met.
• In the illustrative whole-fund waterfall, $180m is split $164m to LPs and $16m to the GP, which is 20% of the $80m profit.
• Deal-by-deal waterfalls pay carry earlier, so LPs rely on a clawback, often backed by escrow.