Carried interest, in essence, is a profit-sharing scheme. Investors in private equity, venture capital and other private market funds agree to pay a premium to fund managers if returns exceed a certain level.

“Institutional investors typically pay a 2% management fee and 20% performance fee on profits beyond an agreed threshold, called carried interest,” Steffen Pauls, CEO of Moonfare, a digital marketplace for private market investments, has .

The management fee is meant to cover overhead expenses. The performance fee is meant to align fund managers’ interests with those of the investors.

“Carried interest is often only paid if the fund achieves a minimum return known as the hurdle rate,” according to . In many jurisdictions, “carried interest typically qualifies for treatment as a long-term capital gain taxed at a lower rate than ordinary income.”

Hurdle rate

In an interview last year, Hind El Gaidi, head of valuation and marketing at the private equity firm Astorg, said that carried interest was widely misunderstood. Sometimes people outside the financial sector have said to her that fund managers are “earning too much carried interest”. However, carried interest is only earned “when you’ve done exceptionally well,” she said. “You don’t get it no matter what.”

El Gaidi told Delano: “First you give the return to investors, the return that you’ve promised. So that’s what we call the hurdle, the 8%. And anything above that you share with the investor. You say, ‘Well, I managed to be above the return that I promised you’.... and then the idea is that we share that upside together. And this is the carried interest.”

She continued: “So the more carried interest you have, it means the more you were smart in buying or smart in selling, or the combination of both, or very good [at revamping] a company and presenting it differently, that it created a lot of value. And today, I have to be honest, the value we create with leveraging, the financial engineering part where we just put on debt, that’s very limited compared to the value we create in terms of your bottom line in the company [that a fund has invested in], operationally speaking.”

Alignment

Different firms have different policies on how carried interest is distributed to employees, El Gaidi explained. Sometimes the profits are shared just with partners or with partners and directors, and sometimes with other staff members.

Previous jargon busters in the series: ; ; and .

Next week’s jargon buster: comfort letters.