How carried interest works in private equity

Private equity is a more desirable industry to work within than investment banking. If you work in private equity, you will get to invest rather than to just advise. You will get to 'add value long term,' rather than to suggest acquisitions that will bump up a corporate's share price. And you will get paid more.

Exhibit number one in the partiality that bankers have for private equity is Michael J. Cavanagh, the 48 year-old co-head of JPMorgan's investment bank who quit the bank last month for private equity fund Carlyle. As a top person at JPMorgan, Cavanagh earned $17m in his last year. Over the same period, the top three people at Carlyle shared compensation of $750m.

How come private equity professionals earn so much? Exhibit number two is the chart below, taken from a note by Luke Montgomery at Bernstein Research.

How carried interest works in a private equity fund 

 

The chart above explains carried interest - or the share of the returns on a private equity investment that are distributed to the firm's limited partners (LPs) and its general partners (GPs).

How is carried interest calculated?

A typical private equity fund has a hurdle rate (usually a 7-8% return on its investment), says Montgomery. Below this, any returns on its investments will accrue only to a select group of limited partners. However, once this hurdle rate has been breached, the general partners are entitled to a 20% cut on anything above the hurdle  and on everything that has been generated already below the hurdle. Post-hurdle, funds enter a so-called "catch-up phase," says Montgomery. During this phase, 80-100% of subsequent distributions (returns) accrue to the GPs, until the GPs' carried interests equal 20% of the entire returns so far.

When private equity funds hit their hurdles and start paying carried interest, they can therefore be incredibly lucrative places to work. This is why people get out of banking and into private equity.