Carried Interests Definition
What are carried interests? Carried interest is a portion of an investment fund’s annual profit that is given to the fund manager at the end of the year. Carried interests are designed to incentivize to the fund manager to achieve outstanding performance for the fund. They are often set at around 20% of the fund’s profits.
You can also call carried interest carry, or profit interests. Use the amount to compensate fund managers and general partners at private equity firms and hedge funds. The carried interest may be the primary source of compensation for the fund managers; however, it does not include any of the fund manager’s own money that he may have invested in the fund.
There may be a hurdle rate of return stipulated, as well. For instance, the policy at a private equity fund may be that all of the investors must earn at least 7% return on their initial investment. In addition, the policy may consider everything above and beyond that pure profit and may use it to compute the fund manager’s carry.
Carried Interest Example
For example, a hedge fund has $100 million of invested capital from 10 investors. The hedge fund has told the investors to expect at lease a 5% return on their investment. In addition, the fund manager will earn a 20% carry on the profits above the 5% hurdle rate. Now, motivate the fund manager to maximize the fund’s performance. Furthermore, he will earn 20% of anything above $105 million.
Profit the Fund Manager Gets
Ten investors contributed $10 million each to make the full amount in the fund, $100 million. Each of the investors was told to expect at least a five percent return on their investments, or $500,000 each. For all ten investors, this adds up to $5 million. This means, according to the hurdle rate, the fund manager earns 20% on anything above $105 million.
The fund made $25 million. So subtract the $5 million for the hurdle rate. That leaves you with $20 million. Now, the fund manager earns 20% of the $20 million. This turns out to be $4 million. Then distribute the remaining $16 million among the investors or use it to cover other expenses or simply reinvest it in the fund.
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