What is Carried Interest in Private Equity?
Explanation
This minimum return is known as the preferred return or hurdle rate, and it sets the benchmark that fund managers must exceed (after accounting for management fees) before they are entitled to a share of profits.
For example, if the hurdle rate is 8%, the fund must deliver at least an 8% return before the manager receives any carried interest.
Since carried interest is only paid once investments are realised, it encourages fund managers to focus on long-term value creation and operational improvements, rather than short-term or interim gains.
This long-term alignment of interests between fund managers and investors is a defining feature of private equity.
Generally, carried interest is distributed only after Limited Partners (LPs) have recovered their committed capital and the fund has surpassed the hurdle rate.
This process follows a predefined structure known as the “waterfall,” which outlines the priority and order of profit distributions between fund managers and LPs.
In some cases—particularly among certain U.S. venture capital (VC) funds—contractual agreements may permit earlier carried interest payments.
However, these agreements often include clawback provisions, requiring fund managers to return previously paid carried interest if the fund underperforms later in its lifecycle.
This structure not only promotes accountability but also ensures that fund managers are incentivised to maximise long-term returns while protecting investor interests.
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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.
