Definition
Carried interest (often called the promote) is a performance-based share of profits paid to the sponsor/manager of an investment—typically after investors receive their return of capital and any agreed preferred return. In real estate syndications and private equity, carried interest is distributed through a waterfall that defines who gets paid, when, and in what proportions.
How It Works
Most deals begin with a baseline LP/GP split (limited partners/investors vs. sponsor/manager), such as 90/10 or 80/20. “Carry†is the extra profit share that the sponsor earns for hitting performance thresholds. The better the outcome, the more the split may shift toward the sponsor.
Typical waterfall order
- Return of capital: LPs receive their original investment back (sometimes pro-rata).
- Preferred return: LPs receive a target return (e.g., 8% pref) before promote begins.
- Catch-up (optional): distributions shift to the sponsor until an agreed split is reached.
- Profit split / tiers: remaining cash flows are split by the promote schedule (e.g., 80/20, then 70/30 above a higher hurdle).
Common Structures
Carried interest can be single-tier (one promote split) or multi-tier (promote increases as performance improves). Hurdles are usually based on IRR, equity multiple, or both.
Examples (illustrative)
- Single-tier: 8% pref, then 80/20 split (LP/GP) thereafter.
- Two-tier: 8% pref, then 80/20 until 16% IRR, then 70/30 above 16% IRR.
- Three-tier: 8% pref, 80/20 to 14% IRR, 70/30 to 18% IRR, 60/40 above 18% IRR.
Why It Matters
Carried interest is meant to align incentives: the sponsor earns more only if investors do well. But structure matters. A promote that is too rich, triggers too early, or relies on unrealistic assumptions can misalign incentives and inflate underwriting.
Investor Uses
- Underwriting alignment: confirm the sponsor’s upside is tied to durable value creation (NOI growth, smart capex, risk control).
- Comparing deals: evaluate different waterfalls on an apples-to-apples basis by modeling net LP returns.
- Negotiating terms: adjust pref, catch-up, and tiers to balance risk and reward.
- Governance focus: ensure reporting, controls, and decision rights match the incentive structure.
Example
Investors contribute $10,000,000 (LP equity). The deal returns $16,000,000 total over the hold period. Suppose the waterfall is: return of capital to LPs, then 8% pref, then remaining profits split 80/20.
- First: LPs receive $10,000,000 back (capital return).
- Next: LPs receive their preferred return (amount depends on timing/hold period).
- Then: Remaining profit is split 80% to LPs and 20% to sponsor as carried interest.
The exact carry dollars depend on timing (cash flow schedule), the pref definition (simple vs. compounding), and whether there is a catch-up.
Common Pitfalls
- Confusing fees vs. carry: asset management, acquisition, and disposition fees are separate from carried interest.
- Early promote triggers: structures that start carry before capital is returned can increase investor risk.
- Catch-up surprises: “100% catch-up†can funnel large early distributions to the sponsor once pref is met.
- Metric gaming: IRR hurdles can be influenced by timing; equity multiple focuses on magnitude but ignores time.
- Not modeling the waterfall: headline splits (e.g., “80/20â€) can hide meaningful tier and catch-up mechanics.