In the world of venture capital, few topics are as central (and sometimes as controversial) as carried interest. For those involved in investments, understanding the concept of carried interest is paramount to deciphering the compensation structure in venture capital (VC) funds.
What is Carried Interest?
Carried Interest, often referred to as “carry”, is the share of profits that a venture capital or private equity fund manager receives from the fund's investments. It's a performance fee, designed to incentivize fund managers to maximize returns for their investors. Historically, carried interest has its roots in the maritime industry where ship captains were compensated with a share of the cargo's profits if they successfully navigated the ship to its destination.
The Standard Model: "2 and 20"
The typical fee structure for venture capital funds is often referred to as "2 and 20", meaning:
2% Management Fee: This is an annual fee calculated based on the total assets under management. It's intended to cover the fund’s operating expenses such as salaries, rent, and research.
20% Carried Interest: This is the performance fee, or the share of profits, that the VC firm receives. It's typically set at 20%, although it can vary.
It's worth noting that while "2 and 20" is the traditional structure, there are variations based on fund size, strategy, and the reputation of the managing partners.
Hurdle Rate and Waterfall Structure
Not all profits are immediately subject to carry. Many VC funds have a “hurdle rate” or “preferred return” which sets a minimum return that the limited partners (the investors in the fund) must receive before the general partners (the fund managers) can claim their carried interest. For instance, with an 8% hurdle rate, the fund would need to return the original principal plus an 8% annual return to the limited partners before the general partners start receiving their 20% carry. The process by which returns are distributed is often termed as the “waterfall structure”. Here’s a simple breakdown:
Return of Capital: Initial returns go towards returning the capital contributions of the limited partners.
Hurdle Rate: Any returns after the initial capital are returned to the limited partners until the hurdle rate is achieved.
Carried Interest: After the hurdle rate is achieved, subsequent profits are split, typically with 20% going to the general partner (as carry) and 80% to the limited partners.
Imagine a VC fund with a size of $100 million. Over a period, let's say the fund made investments which are now worth $250 million. The profit is: Profit = $250 million - $100 million = $150 million. If there's an 8% hurdle rate on the initial $100 million, the first $8 million in profit would go entirely to the limited partners. The remaining profit is $142 million. From this, the general partners would receive 20% as carried interest, which is: Carried Interest = 20. The limited partners would get the remaining 80% of the $142 million, which is $113.6 million.
Controversies Surrounding Carried Interest
Carried interest has been a topic of debate, especially in the U.S., largely because of its tax treatment. The income from carried interest has been treated as long-term capital gains (subject to a lower tax rate) rather than ordinary income. Critics argue that it should be taxed as ordinary income since it resembles a performance-based bonus more than an investment return.
Carried interest is a cornerstone of the venture capital compensation model, incentivizing fund managers to generate superior returns for their investors. As with any investment, understanding the fee structure and potential conflicts of interest are key considerations for limited partners when evaluating venture capital opportunities.