Venture capital (VC) is one of the premier jobs for recent business school graduates. People will suffer through years of 80-hour weeks in investment banking and, even worse, graduate-level finance courses, just to get an interview with a venture capital fund.
So what attracts the tired masses? The fast-growing businesses? The opportunity to wear suits without a tie to work every day? The chance to live in California? Mostly, it’s the money.
Venture capital firms are set up to offer massive returns to investors, and, if they do, the general partners will earn their share of that massive amount of money.
Overview: What is carried interest?
The general partners in the fund are the owners/managers of the firm. Limited partners are the investors. The limited partnership agreement spells out the pay structure for the fund, likely including management fees and carried interest.
Management fees are straightforward: The general partners are paid a percent of the total investment capital each year.
Carried interest is a little more complicated. The incentive for VC firms to generate massive returns is a percent of the gains in the fund. Carried interest is the percent that is paid out to general partners.
You’ll often hear the term “2 and 20” as the fee structure for many venture capital funds, private equity funds, and hedge funds. This means the fund earns a 2% management fee and 20% carried interest.
Types of general partner compensation
Here are the three different kinds of general partner compensation.
1. Management fees
Management fees keep the lights on. The 2% fee is used to pay analysts, associates, and administrative personnel. It’s also used to pay for legal fees, accounting expenses, and software costs.
You may see some hedge funds with limited personnel waive management fees, but big venture capital funds will charge it.
The incentive pay is what makes VC attractive to employees and general partners. With a 20% carried interest provision, general partners earn 20 cents for every dollar of return to limited partners in the fund.
3. Fund returns
Many general partners will invest in their funds. Any returns on investments are then paid out to them (and they don’t have to pay the carry to themselves), in addition to their other pay.
Investors may seek out general partners who will put their money where their mouth is and make a significant investment in their own fund.
How venture capital carry works
Here are the key items to know regarding carried interest:
- Carried interest is only paid on exits: You can use financial projections to value current portfolio companies and try to figure out what the fund’s current returns are, but the general partners won’t be paid until investments are actually exited. Exits are typically after an initial public offering (IPO) or a sale of the business.
- Carry is paid per deal: Limited partners make a commitment for a certain amount of dollars, and then when the VC finds an investment for a portion of the fund, they send out a request for funds for the purchase. Once that investment has an exit, the VC is paid carried interest if 100% of the invested capital is paid back to limited partners.
- There could be a hurdle rate: In addition to not earning carried interest until the investment is paid back, many agreements will restrict paying out carried interest until a hurdle rate has been met. Hurdle rates are often around 6-8% and are more common in hedge funds and private equity funds.
- Clawbacks: If a fund has a high early return on its first investment and then makes several investments that fail, the carried interest from the earlier investment may be clawed back to limited partners to make them whole on the later investments.
- Premium carried interest: Some funds will negotiate an increase in carried interest once the fund has returned a certain amount.
- Taxes: Taxes on carried interest are a hotly contested political topic. Currently, carried interest is taxed like a capital gain. This is what allows billionaire VC managers to pay tax rates of 15-20% on their income. The IRS has started adding restrictions on how firms can claim income is carried interest, and there is an active bill that would cause carried interest to be reported as income. This could increase taxes on some general partners by as much as 25%. There would likely be changes in carried interest amounts if taxes increased by that much.
An example of venture capital carry
High Returns Limited (HRL) is a well-established firm with a history of high-performing funds. It recently raised a new fund with $200 million in committed assets under management and is charging 2 and 25, or a 2% management fee and 25% carried interest.
Typically, a successful VC would not have a hurdle rate, but HRL is confident in its ability and negotiated an increase in carried interest — 25% instead of the typical 20% — in exchange for the hurdle rate. HRL must earn 8% before carried interest is paid. The way this hurdle rate is structured, HRL earns its carried interest on the full profit amount once the hurdle has been reached.
We’re going to look at HRL’s first year — when it lucked out and exited from two investments.
The first part of the calculation is the management fee. At 2% of $200 million, HRL was paid $4 million by its limited partners to manage the fund.
The first investment HRL made was $10 million in the last round of a high-flying tech company. The investment was made fully expecting an exit within a year when the company held an IPO. With the IPO, the fund generated a 40% return. Forty percent of the $10 million is a $4 million return, so the carried interest on the $4 million in profit is $800,000.
The second investment did not fare as well. It was in a startup tech company selling a set of smart bowls. The bowls made meditation sounds, and customers would pay a monthly subscription for custom meditation sessions. When the founder left the company to go live in the mountains of Tibet and discover himself, the fund was able to steer the company into a sale to an exercise subscription website.
Unfortunately, the sale of the company returned only $1.5 million of a $2 million investment. This fell short of the return of invested capital requirement and, of course, did not reach the hurdle return rate. General partners were not paid out on the investment.
The total pay to general partners for the year was $4.8 million. The current total profits returned to investors are $3.5 million. HRL’s carried interest of $800,000 is more than 20% of the total profit. If it does not increase returns going forward, part of the carried interest may be clawed back to limited partners.
Carry the interest
Whether you want to break into the VC industry as an employee or just want to learn how funds work to help attract investment in your company, knowing how carried interest works will put you ahead of the competition.