What Should You Know About Common Carry Percentage in Private Funding?
In venture capital funding, the operating agreements work on the assumption that the investments will generate profits equaling the book value. A carried interest will be calculated on the total proceeds.
The carried interest or carry is the term representing incentive compensation offered to equity fund managers for aligning their interests with the capital-funding investors. It is a percentage of the profits that fund managers can keep above their management fees.
Here is an explanation of common carry percentage with a focus on its integral factors.
Understanding the Common Carry Percentage
The investment team in a start-up or an established business comprises individual fund managers. They identify and manage the investments for the company and receive compensation in two ways.
The private equity fund managers are paid a yearly management fee covering the cost of fund management and investment. Also, they get a carried interest as an incentive for their performance if the fund performs above the predetermined levels.
Typically, the carry percentage averages around 20% of the profits and may go up to 50% in exceptional scenarios. The interest is not paid automatically as the fund managers have to surpass the hurdle rate or the specified return to receive this money.
What Factors Work into the Calculation of Carry Percentage?
The general organizers or private equity managers put a lot of time and effort into improving the fund’s performance over time. They receive a management fee that is justified for their hard work in creating strategies to maximize the fund values and manage the same. They do due diligence research before investing massive parts of the capital.
Once they turn the company back to profitability and restructuring for generating higher returns, it leads to a liquidity event through an IPO or an acquisition. Hence, the carry percentage is usually vested for one to six years.
The investors do not need to bother about shorter vesting periods as they can keep fund managers focused on multi-year carry percentage for long-term profit earnings. Even for taxation, common carried interest is a long-term capital gain when it holds up for more than 3 years.
How Does Common Carry Percentage Work?
An explanation of common carry percentage requires an understanding of its workings too. This percentage works as a primary income source for the general partners. It may amount to nearly a quarter of the yearly profits. The percentage is defined in the operating agreement along with the hurdle rates and distribution allocation.
Let’s understand with an example. Suppose a private equity firm raises $1 billion from general partners and investors, where general partners contribute $50 million, and investors pay about $950 million. Here, the distribution will work as follows:
- The general partners invest the capital through investments in various organizations to earn profits. After five years, they exit these investments and make $2.5 billion as returns. In this scenario, the limited partners will get their $1 billion as the capital returned.
- Out of the remaining $1.5 billion of proceeds, the limited partners and general partners will get their shares in a ratio of 80:20. Here, the GPs earn nearly five times their initial investment.
In private equity funding, carry percentage is an incentive for general partners for successful investments and profitable earnings on the investors’ money.
