Understanding Fees: Carried Interest

Carried interest, or the carry fee, is a type of compensation structure where the investors are paid a fixed return, called the hurdle rate, before the managing members are paid. In a venture capital or private equity fund, the hurdle rate is typically 7-8%. This means that the fund must deliver a 7-8% return on investment to their investors before the fund managers begin to take profit. The typical carried interest rate is about 20%. This means that once investors have received the return in the hurdle rate, the remaining profits will be divided up with 80% going to the investor and 20% going to the managing members.

Example 1:

In this example, let's say an investor invests $1000 in a property on Peerinvest. The property performs well and delivers a return of $500 this year. The hurdle rate is 8% and the carried interest rate is 20%. The investor first receives $80 ($1000 * 8% hurdle rate). The remaining earnings ($420) will be divided as $336 (80% * 420) to the investor and $84 (20% * 420) to the managing members as the carry fee. So on a $1000 investment, the investor would have made $416 ($80 + $336) this year.

Example 2:

In this example, let's say an investor also invests $1000 in a property on Peerinvest. However the property has a tough year and only delivers $80 in profit. In this scenario the investor receives $80 ($1000 * 8% hurdle rate). Since there is no money remaining after the hurdle rate has been paid, there is no profit to split. In this scenario the investor would review $80 and the managing member would receive nothing.

So why use a carried interest fee? It aligns the managing members interest with the investors. It guarantees that the managing members don't get paid unless a certain amount of profit has been delivered to the investors.

Disclaimer: PeerInvest is not a financial advisor and this post is for informational purposes only. Please consult a financial advisor before acting on the information in this post.