Carried interest and promote modeling. In this course, we will discuss issues related to the fee and return structure in private equity focusing on the management fees and the carried interest. The calculation of the carry is part of the distribution waterfall and it includes the return of capital, the catch-up provision, and lastly, the carried interest itself. We'll also discuss a promoted interest or "promote" which is a similar concept applied to real estate investments.

Private equity fund managers are compensated in two different ways with regards to their investment funds. The first way is the management fee, which is based on a percentage of the funds raised. These are funds that the general partners or GPs will eventually invest in projects.

For smaller funds, fees range from 2 to 3%, and for larger funds, they're lower, typically in the one to 1.5% range.

Fees are used to cover the private equity firm's operating costs. This is a small part of the overall profitability of a private equity firm, but an important one, as the fees are a kind of annuity that persists even during volatile or less liquid markets. In addition, since the fees are generated on the total assets under management, they accrue whether or not the fund is successful. The more successful the fund is, the more assets grow and more fees are generated. The expenses of a private equity firm, however, tend to not increase along the same trajectory so there are major benefits to growing funds. The second source of profits for a fund sponsor is through the carried interest or "carry." This is the percentage of the profits of the overall deal that the sponsor takes. The term carried interest goes back hundreds of years in the shipping industry. As ships crossed from Europe to Asia and to the Americas, the captain would take a 20% share of the profit from the carried goods to cover the transport cost and risks of sailing over the seas. Now, to translate this into the private equity world, funds are typically broken down by investors or LPs and sponsors, also known as GPs. The LPs tend to invest nearly all of the capital in the fund, typically 90 to 95%. However, the sponsor will generally take 20% of the profits. This is the carry. To entice the LPs to invest, the GPs will offer a guaranteed rate of return on the investment, sometimes called a hurdle. Once the investors, limited partners, or LPs have received their hurdle rate, which is usually around 8%, the GPs will share in the excess over the hurdle rate or the carry, 20% typically, of any excess profits. A waterfall prioritizes the distribution of cash flows between the investors or LPs and the private equity fund sponsors or GPs. In a basic waterfall the LP will receive 100% of all cash flows until the hurdle or the preferred return is achieved. This is called a true preferred as it treats the LP investment differently than the GP. This distribution can also include the return of capital, if it is a European style waterfall. In an American waterfall, the return on the capital is distributed first and the capital itself is returned second. Once either the hurdle is achieved and/or the capital is returned the GP will apply the carried interest percentage, in this case 20%, to the remaining cash flows. The split refers to the percentage granted to the LP and GP, and usually differs from the pro rata invested capital amounts. In complex waterfalls additional hurdles can be used to alter the split again once higher levels of returns are achieved. This will even out the economics in higher grossing deals. Basically the amount paid to the LP will equal the initial hurdle including the capital invested, and 80% of the remaining profits. The GP will earn 20% of the profits. Since the GP invests so little capital in the deal the returns are magnified when positive. As mentioned, the GPs returns can be magnified when the deal turns out to be a good one. Although it is hard to know this going in, even at an 80-20 split the LPs will earn greater than 80% of the overall profits because of the hurdle that was paid first. The GP rarely participates in this. As a result, the GPs will often ask for a catch-up provision that creates a second waterfall distribution to tie the GP in terms of the percentage split. If the deal were a 2 and 20 arrangement, that is management fee of 2% and carry of 20%, with an 8% hurdle, the investor would still earn the 8% hurdle first. Once that was achieved, the GP will then assume 20% of the total distributions paid so far this would be the catch-up. The GP does not reclaim or claw back any distributions already paid to the LP. Instead, the GP simply calculates the catch-up so that the amount paid to the LP in the hurdle calculation represents only 80% of the total distribution. The remaining 20%, which comes out of the proceeds after the hurdle distribution goes to the GP and the second waterfall. Again, this is the catch-up. The profits after the catch-up are then split along the 80-20 parameters. The total split of all distributions in this kind of arrangement is a true 80-20, making this a preferred method for GPs. A carried interest and a promote are essentially the same thing. Carried interest applies to private equity and promote specifically to real estate transactions. Promotes represent the sponsors disproportionate share of profits in a real estate deal above a predetermined return threshold. Why does the sponsor deserve to earn a promote? The reasons are the same justification for the carried interest, so let's examine them. The GP is responsible for finding the transaction, negotiating the offer terms with the seller, performing the due diligence, securing and signing on to the debt, and managing all aspects of ownership, including proposed renovations until disposition.

Let's look at the equity waterfall for a real estate promote a little more closely. Here we have an acquisition funded by 60% debt and 40% equity. The GPs have invested 10% and the LPs have invested 90%. The GPs have offered an 8% hurdle rate, which means that each investor group will share in the first 8% of yield according to the pro rata investment. This is what is known as a pari-passu investment. Both capital investments by the LP and the GP are considered the same. The GPs will then take an additional 30% of the LP profits after that 8% has been achieved. This is a promoted interest. Graphically, the deal looks like this. The levered cash flows will flow to the GPs and LPs until they achieve an 8% return. Again, this is what is known as a pari-passu preferred. It is also possible to treat this preferred as a true preferred. Once that hurdle has been achieved, the remaining cash flows are profits to be shared. However, the GP has a 30% promoted interest so it will receive 10% of the remaining cash flows according to its pro rata investment, plus 30% of the 90% that the LP was supposed to receive. The 90% refers to the LPs pro rata investment. Lastly, the LPs will receive their stake which represents 70% of the 90% according to their pro rata investment.