Carried interest valuation: What are the benefits, and how does it work?

What is taken interest?Carried interest is a share of profits earned by private equity general partners. The valuation of carried interest is made according...
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Carried interest valuation: What are the benefits, and how does it work?

What is taken interest?

Carried interest is a share of profits earned by private equity general partners. The valuation of carried interest is made according to the roles of the general partners. Carried interest valuation is not made on the initial investment of the partners. This type of interest is paid only when the initial funds achieve a minimum return on the investment. It works like alternative asset valuation for clients, giving them a higher return on their initial investment.

How does carried interest work?

Most funds must perform to an extent before the carried interest is paid to the client. As per rules and protocols, the investment must also be held to a specific time before the members of the carried interest get the benefit. Like in the US, the funds have to be held for three years; however, the duration is different for the UK.

The total amount of carried interest is divided among the participants. If the maintained interest plan brings a profit of 25%, then an individual may get as little as 1%, depending on several factors like the number of participants, yield, duration, etc.

How carried interest is calculated?

The valuation of the carried interest involves a hurdle rate or preferred return, which means the investor who has invested a fund into it will receive a predetermined return on the initial payment that an individual has made. If a fund has a hurdle rate of 8%, the manager will receive the carried interest only after the investor gets an 8% return on the initial investment.

Let us understand the carried interest using an example:

If funds are raised equal to $100 million, then a 2% management fee and 20% of carried interest with an 8% hurdle rate is paid to the investor. If the fund returns $150 million after its sale, then the investor will get $108 million, including the initial investment plus return plus hurdle rate. However, the manager will receive 20% of the rest $42 million, which means the manager will get $8.4 million.