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Carried Interest in Private Equity (Definition) | Examples | Accounting - YouTube
Channel: WallStreetMojo
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hello everyone hi welcome to the channel
wallstreetmojo today we have a topic
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with us is called carried interest in
the private equity watch the video
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till the end also if you are new to this
channel then you can subscribe us by
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clicking the bell ican now we all know
what private equity is all about by far
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now but carried interest is one such
topic that you need to understand in
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private equity how does it operate in PE
let's try and understand over here the
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president Donald Trump tax plan will
likely curb the carried interest tax
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loophole after all so even Donald Trump
hasn't left this unturned the stone
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unturned so we'll try and understand
this first what is the carried interest
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in PE
in PE
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okay see carried interest is also known
as your carry and as a share of the it
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is the share of the profit okay that is
owned by the private equity fund or the
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fund manager on the exit of the
investment done by the private equity
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fund so this is the most important of
the total remuneration earned by the
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fund manager now it can also be it can
be on the deal basis that earned on
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every deal or whole fund basis generally
the split in profits among limited
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partners that is the investors and the
general partner that is the fund manager
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is closely in the ratio of 80:20
so remember that you know carried
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interest in private equity is not earned
automatically but it will be earned by
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the fund manager it will be earned by
the fund manager only when the profits
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of the fun exceeded a specified returns
but the specified return is known as the
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hardl rate now if the fund manager is
unable to achieve the hurdle rate it
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won't be entitled to receive any sort of
carried interest okay now ii will try
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and understand it this with the help of
an example
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see assuming or private equity fund is
having a carried interest of let's say
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20% for the fund manager and a hurdle
rate of 10% so this is your carried
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interest this is your hurdle rate now
when the profits are realized by the PE
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fund this profit shall be first be
allocated to the limited partner that
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has the investors the process shall be
repeated till the time this profits
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reach a cumulative IRR of impossible so
this 10% shall be calculated on
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the capital amount that have been
contributed by the investors so any
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profits over and about any person shall
be split between the general partners
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and the limited partners using a ratio
of 20% for the general partners
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and remaining 80% for the limited
partner so how does this carried
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interest exactly works let's try and
understand that how does the carried
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interest works well see to understand
this
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the calculation of the carried interest
in private equity let's take in another
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example suppose let's a PE form a ABC
okay
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Capital Partners have raised closely
around $1 billion ok $1 billion
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and funds from the investor in
general partners in in this fund
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investors have contributed let's say $950
million
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managers or the general partners
contribute around let's say 50 million
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dollars okay so 95% was
contributed and by the limited partners
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and 5% was by the general
partners so after receiving the capital
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GP general partners then goes ahead with
making investment in various target
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companies to earned profit now after 5
years of times when the GP will take
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an exit okay all investments and receive
a total of let's say $2.5 billion
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so in this scenario the limited partners
would get 1 billion right first as that
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would be the capital that has returned
now the remaining 1.5 billion shall be
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divided between the lp and the GP get it
it will be divided among LP and GP
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aligned this yes so now what it will be
in the ratio of 80 is to 20 now so the
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LP would get around 1.2 billion and 0.3
billion will go to the GP right so GP
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earned over here 5 X now how 5 X 250
billion divided by 50 on investing $50
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million dollars that comes to 5 X so
remember not all the profits go to GP
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the profits are divided among senior
partners who gets bigger pie while the
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remaining is distributed among the
partners and others well we tried and
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understand this we tried understanding
the finance part let's try and
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understand the accounting portion of
this see
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let's now understand how carried
interest is treated in the books of
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accounts understand you know under the
provision of the income tax who carried
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interest in private equity shall be
classified as the capital gains okay so
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they would be taxed at the capital gains
tax rate but this is favorable rate
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compared to the ordinary tax rate so
most of the critics are of the view that
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you know carry should be charged
you know ordinary tax rate however this
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is very it is like you know is a counter
argued with the point that any increase
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tax would suppress the incentive of the
GP to take such high risk and invest in
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target companies to earn profit for LP
so there are two different views of
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understanding this carry the first is
carry being considered as the profit
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that is transferred from investor to
manager okay and the focus is legal form
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here of the arrangement second is it is
seen that only only as a performance
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fees
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for the general partner so here the
focus on the substance of the
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arrangement so the accounting treatment
would be based on the view adopted by
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for for the carried interest now most
forms continue to account for this on
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the cash basis as a distribution while
other private equity fund would account
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for it on the of cruel basis right so when
such interest is accounted on accrual
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then the carried interest balance needs
to be
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but just a subsequent realization of
investment made as well as you know
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revaluation of the investment that is
made okay so this was the part of the
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accounting portion now I'll try and make
you understand how does things go around
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indeed IFRS as region now see under IFRS
as various accounting standard would
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we have to be considered firstly you
would have to determine a thing called
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liability then a distribution okay this
two things so the standards to be
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considered are IAS 32 and under this the
fund manager is considered as the
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service provide and not as only the owner
so it is treated as per the liability
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more model and not as for the
distribution model and the second is IAS
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37 that is provision contingent
liabilities and continued assets so in
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this as per the agreement entered
indicated interest is treated as on the
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what we call as the accrual basis of
accounting and recorded in each
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financial years in this case the deal by
deal waterfall provision is applied
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wherein the hurdle rate you know is
calculated for each the so here the fund
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has an obligation for each year now
sometimes such interest is settled by
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the way of equity instead of the cash so
in this scenario the transaction shall
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be treated as for the provision of IFRS
to that is share based payments so for
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this purpose of the accounting the
private equity shall measure the
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compensation payable at a fair value of
the services that is received and a
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corresponding entry should be made in
the equity part so overall the impact
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would be you know dilution of the equity
that is attributable to the limited
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partners and no liability shall be
created on the fun well on the final
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conclusion note carried interest in
private equity is basically you can say
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that it's an incentive for a general
partner and for the decision taken by
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them to successfully deploy the money
and earn handsome profits on the limited
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partners money so it is earned by the
fund manager only when the profits of
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the fun exceeds the
how'd you read so that's it for this
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particular topic so that's it
for this particular topic if you have
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