Private Equity Funds structured

Carried Interest in Private Equity: What You Need to Know

For those exploring private equity or curious about compensation structures in this field, carried interest, or “carry,” is essential to understand. This form of performance-based compensation aligns the goals of fund managers with investors. Here’s a breakdown:

What is Carried Interest?
Carried interest is a share of profits that fund managers earn when an investment fund performs well, typically around 20% of the profits. Managers only receive carry if the fund surpasses a set return threshold, known as the “hurdle rate.”

Example Calculation
Imagine a private equity fund raises $100 million and grows this to $200 million over several years. Here’s how carried interest is calculated:

Preferred Return: Investors first receive their initial investment plus an 8% preferred return, totaling $148 million ($100 million plus 8% compounded annually over five years).

Remaining Profits: With $148 million returned to investors, $52 million remains in profit.

Carried Interest: If the carry is set at 20%, fund managers receive 20% of the $52 million profit, totaling $10.4 million.

Disclosure in Financial Statements
Reporting carried interest in financial statements varies significantly between IFRS and Lux GAAP:

Under IFRS, carried interest is generally recognized as revenue or income only when it is highly probable that it will be earned and reliably measured, which is often closer to the fund’s exit. This helps ensure that reported earnings reflect more conservative, actualized income rather than estimates of future returns.

Under Lux GAAP, carried interest can be recognized earlier, potentially even when performance thresholds are met but before the full realization of profits. This approach often leads to earlier revenue recognition compared to IFRS and may show higher earnings in interim periods.

Why It Matters
These disclosure differences are essential for stakeholders when interpreting financial statements, as they can affect how and when profits are reported. Understanding the distinctions between IFRS and Lux GAAP provides insight into a fund’s actual performance and the timing of manager compensation. Clear disclosure supports transparency and comparability, helping investors make better-informed decisions.

Carried interest is a key part of private equity’s reward system, balancing investor protection with manager motivation. Knowing how it’s structured—and reported—gives a better picture of what drives private equity managers and shapes the industry’s financial outcomes.