How Carried Interest Works In Private Equity
Explanation
Understanding Carried Interest in Private Equity: A Practical Guide (UK-Focused)
Carried interest, also known as a performance fee, is a key incentive mechanism for General Partners (GPs) in private equity funds. It represents a share of profits from the fund’s investments and is designed to reward fund managers for delivering strong returns.
What is Carried Interest?
Typically set at 20% of a fund’s profits, carried interest is only payable once Limited Partners (LPs) have received both their original capital and a minimum return known as the preferred return or hurdle rate. In the UK and Europe, the standard approach calculates carried interest on a “whole fund” basis, meaning the fund must perform overall before GPs receive a share of profits.
A common preferred return is 8% per annum, which must be achieved before carried interest is triggered.
Carried Interest in Practice: A Simplified Example (GBP)
Let’s consider a private equity fund structured as follows:
- The LP commits £100
- The GP commits £10 (10% of total capital)
- The LP also pays £4 in fees (the GP does not pay fees)
Scenario 1: Fund Returns £90
Losses are allocated proportionally:
- LP receives: £81.82
- GP receives: £8.18
No carried interest is paid.
Scenario 2: Fund Returns £120
The capital, fees, and part of the preferred return are repaid to the LP:
- Capital returned: £100 (LP) + £10 (GP)
- Fees reimbursed to LP: £4
- Preferred return to LP: £8.32
Since the fund hasn’t exceeded the hurdle by much, the GP receives no performance fees.
Scenario 3: Fund Returns £150
The fund exceeds the preferred return and triggers carried interest:
- LP receives capital + fees + preferred return = £122.32
- Catch-up to GP: 20% of preferred return = £2.08
- Remaining profit (£150 – £124.40 = £25.60) split 80/20:
- LP: £20.48
- GP: £5.12
- Total GP Earnings: £2.08 + £5.12 = £7.20
Summary Table
| Fund Return (£) | LP Receives (£) | GP Receives (£) | Carried Interest Triggered? |
|---|---|---|---|
| £90 | £81.82 | £8.18 | No |
| £120 | £120 | £0 | No |
| £150 | £142.80 | £7.20 | Yes |
Carried interest aligns the long-term incentives of GPs with LPs by ensuring performance-based rewards are only granted once investor capital and minimum returns are secured. It is a defining feature of the private equity model and remains essential in evaluating fund structures.
View More Definitions & Explanations
The Origins and Evolution of Private Equity
Private equity (PE) has grown into a global financial powerhouse, but its beginnings can be traced back to the post-World War II era. The formation of the American Research and Development Corporation (ARDC) in 1946 marked one of the earliest institutional private equity efforts.
ARDC’s mission was to fund companies that could repurpose wartime technologies for commercial use. One of its landmark investments was in Digital Equipment Corporation (DEC). A modest $70,000 investment in DEC eventually turned into $355 million, delivering a return of over 5,000 times the original amount. This staggering success demonstrated the potential of private equity to fuel innovation and drive extraordinary financial outcomes.
The Rise of Leveraged Buyouts in the 1980s
The 1980s became a transformative decade for private equity, largely due to the emergence of leveraged buyouts (LBOs). Pioneering firms such as Kohlberg Kravis Roberts (KKR) led this movement, acquiring companies primarily through borrowed capital, implementing operational improvements, and exiting through strategic sales or IPOs. These deals often resulted in significant returns and played a key role in legitimizing private equity as a powerful tool for value creation.
Private Equity Today: A Global Asset Class
Fast-forward to today, and private equity has evolved into a multi-trillion-dollar global industry. PE firms are actively involved in reshaping key sectors, including technology, healthcare, financial services, energy, and consumer goods. The United States continues to dominate the market, but institutional investors are increasingly turning their attention to opportunities in Europe and Asia where valuations are more attractive and growth potential remains robust.
In recent years, PE has also embraced thematic and impact investing. Many funds are aligning their strategies with ESG (Environmental, Social, and Governance) principles or specific global trends, such as digital transformation, renewable energy, and health innovation. This not only broadens investor appeal but also enhances the sector’s influence on global progress.
The Dominance of Private Companies
One compelling statistic underscores the importance of private markets: approximately 83% of U.S. companies with over $100 million in revenue remain privately held. This highlights the vital role of private equity in financing, developing, and scaling enterprises outside the public markets.
In summary, private equity has evolved from a niche investment strategy to a dominant force in global finance. With its origins in innovation and a future driven by strategic investment, operational excellence, and global diversification, PE is positioned to remain a key player in shaping tomorrow’s economy.
