The Many Flavors of Carry

Private equity firms with a solid track record can negotiate carry, fees, and payout arrangements that are favorable to the General Partner. Newer firms are at a slight disadvantage when negotiating compensation. As a result, management fees, carry, payment approaches, and profit calculation formulas are negotiated terms that vary from firm to firm.

As a result, there are many different carry structures of varying complexity. For example, some private equity firms determine carry on a deal-by-deal basis while others spread it across all the firm’s investments. Sometimes, carry is granted up-front for the life of the fund, other times it is granted annually. Formulas also vary on how carry might be forfeited for those who leave the firm.

Whole-of-Fund Carry

With whole-of-fund carry, the General Partner can only withdraw carry after achieving a hurdle rate on the entire capital invested and after Limited Partners have received their capital and returns. Essentially, Limited Partners have a preferred right to returns. This structure protects investors against early payments of carry on funds that ultimately do not perform to agreed hurdle rates. It also benefits fund managers by lowering tax rates on carry.

Certain countries, such as the U.K., allow a base cost shift tied to inflation that increase the cost of the asset each year and reduces base cost and tax on carry held for longer periods, as typically happens with whole-of-fund. This does not apply for the U.S. where there is no inflation-related increase in base cost.

Investments at a private equity firm are typically made by a small team of managing partners. One executive’s investments may do really well, while another’s may lag. Whole-of-fund only rewards collective success; it does not reward individual performance. Therefore, managing partners must be very comfortable with shared risk and rewards when they sign-up for whole-of-fund carry. Whole-of-fund also draws out the timeframe over which fund managers get rewarded – while this may be okay for senior executives, it may frustrate ambitious junior executives who may want faster access to cash so they can move on to better opportunities at other funds, so they can buy a house or that Ferrari the have been eyeing. Although this approach encourages fund managers to collaborate and improve overall performance, it could also foster adverse interpersonal relationships within the firm’s investment team.

Deal-by-Deal Carry

Most fund managers prefer a deal-by-deal carry arrangement where carry payments are made on each deal that meets or exceeds its performance levels, after investors are paid back their capital and returns for that specific deal. To protect investors, some firms structure deal-by-deal carry with escrow or “claw-back” arrangements. While deal-by-deal carry rewards individual investment performance and shortens pay periods, it takes away the tax benefits of whole-of-fund and has its own set of adverse and advantageous ramifications.

Deal-by-deal carry increases investor risk, for which investors demand additional reward. Therefore, deal-by-deal arrangements tend to have lower carried interest. For example, one of Europe’s top private equity firms has a deal-by-deal arrangement with only 10% carry.

Take As You Go Carry

Take-as-you-go is a hybrid compromise where payments are made to carry from the returns of a particular investment after investors have been paid their principal and hurdle on that specific deal and have been made whole on investments and preferred returns from past deals.

For example, say Deal-One resulted in a $1 million loss of investor capital but Deal-Two realized outsized gains. Because Deal-One resulted in a loss, it has no carry. Carry on Deal-Two is only paid after investors have been made whole on Deal-One (i.e. paid $1 million capital plus a preferred return) and paid capital and hurdle on Deal-Two.

Phantom Carry

Phantom carry, also called synthetic carry, is basically a bonus pool funded from carried interest dollars based on fund performance. This bonus pool is used to give lower level team members (pre-MBA junior analysts, admin staff, etc.) an incentive and an opportunity to share in the firm’s upside. Phantom carry itself comes in different flavors conjured up by the firm’s managing partners, with some guaranteeing payments while others do not, with varying tax treatments for each.