What is Carried Interest in Private Equity?

Carried interest, also known as “carry,” is the share of the profit earned by a Private equityPrivate EquityPrivate equity (PE) refers to a financing approach where companies acquire funds from firms or accredited investors instead of stock marketsread more 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 earned on every deal or a whole fund basis. Generally, the split in profits among the limited partners, the investors, and the general fund manager partner are 80:20.

Remember, Carried Interest in private equity is not earned automatically. It will be earned by a fund manager only when a fund’s profits 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.read more. If the fund manager cannot achieve the hurdle rate, it won’t be entitled to receive any carried interest.

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Carried Interest Example

Assuming a Private equity fund has a carried interest of 20 % for the fund manager and a hurdle rate of 10 %.  When a PE Fund realizes the profits, these profits shall be first allocated to the limited partner, Investors. This process shall be repeated until these profits reach a cumulative IRR of 10%. This 10% shall be calculated on the capital amounts that the investors have contributed. 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 does 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, has raised $ 1 bn funds from Investors & General partners. Investors have contributed $950 million to this fund, 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 makes investments in various target companies to earn profits.After five years, the GP exited all investments and received $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 are distributed among 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 critics believe that carry should be charged at an 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 is 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 the 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.read more 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 after the realization of investments made and 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 orA distribution

The standards to be considered are -:

  • IAS 32 – Financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more – The fund manager is considered a service provider and not 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.read more – 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 IFRS 2 – “Share-based Payment.” For accounting, the Private equity fund shall measure the compensation payable at the fair valueFair ValueThe fair value of an investment is the asset sale price that is agreeable to both the buyer and the seller. There is a caveat; the amount should be agreeable in a free trade scenario; there should be no external pressure or conditions.read more 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.

Conclusion

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).read more for their decisions to successfully deploy the money and earn handsome profits on the Limited partner’s money. It is earned by a fund manager only when a fund’s profits 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 –

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