A Note on Carried Interest in Private Equity

Abstract

Investors in private equity funds make payments for fund management fees and for fund investments; they receive capital which comes from the sale of these investments and that capital is net of carried interest. The carried interest is non-zero if the fund has returned sufficient capital back to the investor (and is zero otherwise). The calculation of the carried interest is complex and investors usually do not track the total amount of carried interest accrued. This means that investors cannot have a historical and comprehensive perspective on carried interest. However, because carried interest is paid only if performance is good, it is commonly thought that tracking carried interest does not matter anyway. Yet, because this fee is non-linear and investors have a portfolio of funds, significant carried interest can be paid even when the private equity portfolio has shown poor performance. This means that tracking carried interest is economically useful. Data from three large US pension funds is used to illustrate. Statistics are remarkably similar across these investors. Estimated carried interest is about $5 billion, which represents about 13% of capital invested, 19% of overall profit and 38% of profits above a standard benchmark (8% per annum over four year). Given past performance, past carried interest paid does not appear to be a major issue. Yet, the conclusion depends on the benchmark used, the estimated absolute amount of carried interest is significant, and if future performance differs from past performance, the way carried interest is currently computed could be problematic for investors going forward.