Carried Interest Explained: How it Works and Who it Benefits
Carried interest (often known simply as “carry’) is the main way that fund managers and angel syndicate leads get paid for their work.
In short, carried interest is a share of the profits from an investment made in a fund or SPV. It is paid to the fund manager or syndicate lead when portfolio investments are sold at a profit. Carry is designed to align the incentives of the investor and the manager / lead.
In simple terms:
Carried Interest is the percentage of profits from a Fund or SPV that are paid to the manager / lead.
The typical carried interest rate charged to LPs in a fund is 20%. For syndicates, a slightly lower rate of 15% is generally considered more acceptable (more on why below).
The carried interest paid to the fund manager or syndicate lead is directly impacted by the performance of their investments. If the investments don’t perform, they won’t make any money.
For example, let’s say you invest $100,000 in an SPV via Odin. The Syndicate Lead charges a carried interest of 15%.
8 years later, the company sells, and your $100,000 investment has turned into $1.1 million, yielding a profit of $1m.
You will receive back the $100k you invested, plus 85% of the profits - $850,000 - so $950k in total. The remaining 15% of profits - $150k - will be paid to the Syndicate Lead. This is their carried interest.
If the company sells at a loss, and your investment is only worth $50,000, then the Syndicate Lead will not earn any carried interest. They only profit if you profit, so they are incentivised to work hard to select high-quality investment opportunities and work closely with the people operating the business to ensure its success.
Deal Carry vs. Fund Carry
Not all carried interest is the same.
Angel syndicates investing via SPV’s on Odin charge carry at a deal-level, rather than across the entire portfolio of investments (which is how a fund charges carry). This can have a significant impact on your profits as fund manager or syndicate lead. It is one of the reasons that deal by deal investing with syndicates can actually be more profitable for the lead/manager than raising a fund.
As a fund manager, you might invest in 20 or 30 companies from a single fund. Venture capital investments typically show a power law distribution of returns. So one company might return 50x on the invested capital, a few will return 2x or 3x, and the rest will break even or lose money. When you invest from a fund, the total return is calculated by taking the average of all the investments you made - so even though one company returned 50x, your total return across the fund might only be 3x - 4x (i.e. the average of 50x + 3x + 2x + 1x + 0.5x + 0.5x + 0x …etc.).
If you invest deal by deal, like angel syndicates do, then the carry is charged on each individual deal, not across all the deals your syndicate invests in. As a Syndicate Lead, this means you only need one hit to make a lot of money! Overall, this can actually be the difference between, say, earning a few hundred thousand dollars, and several million dollars.
When you are investing in a venture capital fund, there will often be a hurdle rate, or a threshold rate of return, that must be met before the fund managers are entitled to receive their carried interest.
The hurdle rate is established at the time the fund is created and is typically benchmarked against the rate of return that the investors in the fund (also known as Limited Partners - LPs) could achieve if they invested their money in a similar, but less risky, asset class, like public stocks.
The typical hurdle rate in VC is around 7-8%. This is the sort of annual return an investor could reasonably expect if they invested their money in, for example, an S&P 500 Index Fund. That fund is fully liquid, meaning they can withdraw their money at any time, so if they are investing with a VC and locking up a significant sum of money for 10+ years, they want to see an annual return above 7-8%.
What this means is that if the fund doesn’t return more than 7-8% per year in cash once it is wound up, the fund managers do not receive any carried interest.
When you are investing in an SPV with an angel syndicate, there may also be a hurdle rate, but hurdles are generally less common in syndicate investing. There are a few reasons for this, but the main one is that syndicates do not generally charge management fees (cash fees for managing the investment process), so their hurdle is lower since carried interest is the only way the Syndicate Lead gets paid.
When it comes to VC funds, there are two different methods for distributing carried interest: the European waterfall and the American waterfall. The difference lies in how the profits are allocated after the hurdle rate is met.
In a European waterfall, the profits are distributed to the LPs first, until they have received their initial investment plus the hurdle rate of return. Only then does the fund manager start to receive their carry.
In an American waterfall, the profits are distributed to the manager first, until they have received their carry, and then the remaining profits are distributed to the LPs. If, once the entire fund is wound up, the managers have actually underperformed and have been overpaid on carry, then usually there will be a clawback clause in place, forcing the manager to return money to the LP’s
Tax Treatment of Carried Interest
In most countries, carried interest is generally taxed as a capital gain (usually a lower rate of tax) rather than ordinary income (a higher rate of tax). However, this treatment has been the subject of debate. Recently, some countries have enacted legislation to change how carried interest is taxed.
It is important to note that tax laws and regulations are subject to change, so it's always best to consult a tax professional for the most up-to-date and accurate information.
Syndicates on Odin
If you have access to quality deal flow and want to set up a syndicate and earn carried interest, get in touch with the Odin team for a chat!