How do you calculate carried interest for a venture capital fund? (2024)

FAQs

How do you calculate carried interest for a venture capital fund? ›

The basic formula for calculating carried interest is: Carry = (Fund's Net Profit - Hurdle Rate

Carried interest is generally private equity fund partners' chief income source. While such earnings generally place the partners in high tax brackets, carried interest is usually treated as long-term capital gains, meaning it is taxed at 20 percent if held longer than three years.

Carried interest, or “carry” for short, is the percentage of a private fund's investment profits that a fund manager receives as compensation. Used primarily by private equity funds, including venture capital funds, carried interest is one of the primary ways fund managers are paid.

The carried interest loophole has long been used by executives of hedge funds and private equity firms to re-characterize their compensation and secure a lower tax rate or put off paying taxes indefinitely.

Also known as carried interest (or carry), this cut of the fund's returns often makes up a large portion of what a full-time VC makes in take-home pay for managing the fund. Carry is considered a return on investment, and is taxed as a capital gain.

The basic formula for calculating carried interest is: Carry = (Fund's Net Profit - Hurdle Rate) x Carry Percentage The fund's net profit is the total amount of money that the fund returns to its investors after deducting all the costs and fees.

“Typically, senior VC partners have between 15% and 25% of the carry of the fund they manage.” “Not all funds will generate solid returns,” caveats Hejka of OTB Ventures. “If a fund does not achieve its hurdle rate, the partners will not earn any carry.” Here's an example of how carry works.

In investing, the 80-20 rule generally holds that 20% of the holdings in a portfolio are responsible for 80% of the portfolio's growth. On the flip side, 20% of a portfolio's holdings could be responsible for 80% of its losses.

Perhaps the most extreme example of Wall Street privilege is the tax loophole that allows private equity and hedge fund managers to mis-classify their salaries as investment income, and pay the much lower capital gains tax rate – instead of paying income tax like the rest of us.

The Argument Against Carried Interest

It allows them to pay less in taxes at a much lower rate than most other workers and can lead to someone earning $400,000 per year in a lower tax bracket than someone earning $60,000. Specifically, critics allege that it misclassifies how asset managers make their money.

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the carried interest is only paid to the Managers after all investors in the Fund (including Managers on the coinvest) have received an amount equal to their equity invested plus the hurdle rate, and. the managers maintain their co-investment in the Fund for at least five years.

The vast majority of this 20% profit percentage goes to the Partners, Managing Directors, and Managing Partners. Generally, less than 5% of the total gets allotted to the Principals, which means a max of 20% * 5% = 1% of the fund's investment profits.

The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.

The GP's carried interest begins accruing as assets in the fund are sold. It is not usually paid out, however, until the investors receive their investments back plus a minimum expected return, known as the 'hurdle rate'.

In most cases, carried interest is considered a return on investment and taxed as a capital gain rather than ordinary income, usually at a lower rate. Because carried interest is typically distributed after a period of years, it defers taxes in the manner of an unrealized capital gain.