Happy Friday, Funds Family!

This is the first article in a series about how carried interest works in investment funds and SPVs.

Buckle up!

What is carried interest?

As discussed in this article on investment manager (GP) compensation, carried interest is the GP’s share of the profits.

This is different from “guaranteed” fees such as asset management or acquisition fees.

The GP should only get carried interest if the fund performs. 📈 

Other names for “carried interest”

You may also hear people talk about “promote” or “incentive allocations” or similar terms. These are typically referring to the same thing - the GP’s share of the fund’s profits. 💵 

🏦 How is carried interest taxed?

Carried interest is typically taxed at capital gains rates, so long as certain requirements are met. This is often hotly debated by politicians 🔥, some of whom argue that carried interest should be taxed at ordinary income rates.

Management fees, on the other hand, are generally taxed as ordinary income.

How does the GP get carried interest?

Each investment fund or SPV has a section in its governing documents 📜 (LPA, LLC Agreement, or Operating Agreement) called Distributions. It’s usually somewhere in the middle of the document.

If the fund has money to distribute, the “Distributions” section determines how the cash is divided among the fund’s owners (including the passive investors (LPs) and the GP). 💸 

The distributions section is often called the distribution waterfall 🌊.

Example 1: Simple Waterfall for Single-Asset SPV

Let’s look at a real example!

Here, let’s assume the LPs invested $100.

The fund successfully sold the investment for 2x and now has $200 to distribute among the fund’s partners.

What funds would this waterfall apply to?

The above waterfall would be common for a single-asset SPV in venture capital. This vehicle may have been formed to purchase Series A stock in a tech company.

How would this waterfall be written?

The waterfall might be written something like this:

Note: This simplified example assumes the GP did not put any money in alongside the LPs (which is unusual).

Walkthrough of distributions

In this example, we have $200 to distribute.

Pursuant to clause (a) in the waterfall, the first step is to give the LPs their money back - in this case, $100.

After returning that $100, we still have $100 left to distribute ($200 - $100 = $100). 🧮 

Pursuant to clause (b) in the waterfall, any remaining profits are split 80% to the LPs and 20% to the GP. So, we send $80 to the LPs and $20 to the GP.

The $20 received by the GP is the carried interest 💰️ earned by the GP.

Can you distribute things other than cash?

Most fund agreements have a provision called distributions in kind, which allows funds to distribute property other than cash.

This makes more sense for funds distributing securities than other funds (such as real estate). A multifamily fund would not typically be distributing apartment buildings to its investors. 🏨 

Limits on distributions in kind

Even in securities funds, there are typically limits to making distributions in kind.

For example, many funds limit distributions in kind during the fund’s life to freely tradeable securities (i.e., unrestricted public stock). At the end of the fund’s term, it can typically distribute restricted private stock.

Example - Series C Preferred 📈 

If a fund has Series C Preferred stock, it would typically not be able to distribute the stock in-kind to investors until the end of the fund’s life…unless the underlying company goes public.

If the company goes public, the fund would usually have its Series C Preferred stock converted 🔄 into standard common stock trading on the NYSE or NASDAQ.

At that point, the fund could distribute the common stock to investors immediately 📬️ . It wouldn’t need to wait until the end of the fund’s life.

In fact, LPs often prefer that funds distribute the publicly-traded stock instead of holding it within the fund.

Story Time: Please do NOT forget the waterfall! ☠️ 

We once had a potential client who came to us asking for help.

They wanted us to read their fund documents to make sure they were ok. Alas, they were not ok.

While the PPM mentioned a distribution waterfall, the waterfall was missing from the signed LPA 🤯.

Instead, the “Distributions” section said: 📜 “Distributions will be made pro rata to the partners.” In other words, the provision granting the GP the carried interest was…gone.

The PPM is merely a marketing document, while the LPA (or LLC agreement / operating agreement) is the legal document governing the relationship between the GP and the LPs.

So, at the end of the day, there’s a strong argument that the GP in this story won’t get their carried interest…which is…the main reason they started the fund in the first place. 🫠 

I’ll leave it to the litigators to decide how this particular case would shake out, but my warning is clear:

🚨 Do not forget to include the distribution waterfall granting the GP carried interest in your fund documents!!!

Up Next ⏩️ 

Next week, in Part 2, we’ll discuss multi-asset fund waterfalls, including:

• European (netted) waterfalls

• American (deal-by-deal) waterfalls

Should be nothing short of fascinating! 🙃 

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.