🛠️ Investment Fund Key Terms, Part 15

🎉 Happy Friday, funds family!

Today, we have Part 15 in our many-part series walking through each term in an investment fund term sheet in detail.

Last week, we discussed 🛠️ Successor Funds. Today, we'll learn about Carried Interest. 

Carried interest is the magical elixir of investment funds – the GP’s share of the profits. 

➡️ What is Carried Interest?

Carried interest is the performance-based portion of the GP’s compensation. You might hear other terms to describe the GP’s share of the profits, including “promote,” “carry,” or “incentive allocation.” 

This post will merely contain a general overview of carried interest. Future posts will highlight specific aspects of how carried interest works. 

Here’s a (radically) simplified version of how a carried interest provision might work: 

Note that the carried interest is usually described in the “Distributions” section of an investment fund’s LPA. 

➡️ What are the components of a carried interest distribution waterfall?

Here are some common terms in carry waterfalls. We’ll discuss these in more detail in future posts. 

1️⃣ Return of Capital: LP must first receive back an amount equal to their capital contributions.
2️⃣ Preferred Return (Hurdle): LP must receive a priority return after the return of capital. Example might be 8%, compounded annually, on the capital contributions of such LP. 
3️⃣ Catch-Up: The GP may receive 100% of profits for a short period until the GP has received 20% of all profits distributed (including profits distributed to the LP pursuant to the preferred return). 
4️⃣ Profit Split: From that point forward, profits are split 80% to the LP and 20% to the GP. 

The above are just examples. In the wild, you’ll find all sorts of splits, percentages, and structures. 

➡️ Two Common Structures

Here’s a very simplified explanation of the two principal frameworks for how investment fund waterfalls work: 

• Deal-by-Deal (American Waterfall): Carry is calculated per investment — more favorable to the GP.

• Netted (European Waterfall): Carry is calculated only after all LP capital (and pref, if applicable) is returned — more favorable to LPs.

➡️ Clawbacks & Escrows

If early deals do well but later ones flop, LPs might have overpaid carry. That’s why many LPAs include a clawback mechanism whereby the GP must return any excess carry to the fund. Some LPAs require carry to be escrowed in the fund for a time to cover potential clawback risk. 

➡️ Tax Treatment

In the U.S., carried interest may be taxed as long-term capital gains if the fund holds assets for more than 3 years (under §1061 of the Internal Revenue Code). Shorter-term gains? They’re generally taxed at ordinary income rates. 

🗓️ Next up in Part 16: Preferred Returns

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.