Why Carry is Hard to Realize
Lots of discussion around carry and how real it is - here's a thread detailing some of the reasons why the way carry is actually set up is much harder to realize in practice than in theory:
1. Carry is calculated off of fund-level IRR
Carry is typically calculated at a fund-level, not deal-level. This has an important implication. The entire fund needs to perform quite consistently. One donut in a fund requires a 2x MOIC just to bring those two deals back to par. You need a 4x MOIC in one deal to bring the weighted average of those two deals back to a ~2x MOIC. In a fund with ~10 investments that are generally underwritten to ~2 - 2.5x, you need every single other deal to hit a 2.2x MOIC to get back to 2x. If you have two donuts, every other deal needs to hit 2.5x (how many of your funds can consistently hit 2-2.5x?). Arguably, funds that are designed with positive returns convexity should benefit (e.g., similar to Advent's IC which always looks for "breakout potential"). Arguably value-oriented funds suffer here because the chances of getting a 3-5x MOIC in a deep-value fund is low.
2. Carry is calculated off of fund-level NET IRR
Carry is calculated off of net-IRR - i.e., after management fees, carry, and other expenses. This will vary by fund and deployment / return of capital timing, but in general funds can easily have between 500-700 bps of spread between gross and net IRRs. So if you are underwriting your internal ICs (in your 'base case' - wink wink) to a ~20%, that's closer to a ~15% net or lower in practice.
3. Carry is subject to a preferred hurdle rate for the LP
In general, NET IRR must exceed 8% for a GP (sponsor) to actually collect carry. After that 8% (net) hurdle, the next dollar of profit is subject to the negotiated "catch-up" provision. This will vary by fund but let's assume 50/50 GP/LP. For the GP to be "made whole" on its full 20% of carry, the GP in this case will need a net ~12-13% fund (gross 17-20% IRR).
4. Time & Claw-Backs
Typical fund structure is set up with a commitment period, and a harvest period. Let's call these 5 years / 5 years. That means that the last dollar the fund is getting back is not until year-10 (and in reality most funds will have stranded assets that will need to be liquidated at a discount to marked-value - e.g., secondaries).
In an European waterfall, no carry is distributed until return of capital and preferred hurdle is met at a fund-level - so this is very back-weighted. An American waterfall allows you to crystallize carry on a deal-by-deal basis or based on NAV value (depends), but it pulls forward your carry. However, in virtually all cases, there are claw-back provisions with personal guarantees on carry distributed. So if in year 6 you got a $500k distribution and you went out and bought a house and a fund craps the bed later on or some of those valuation marks didn't turn out to be so accurate, the LP (and in turn your fund) will be asking you for that money back (plus interest?).
5. You need to be in the seat to realize carry
Carry docs are negotiated between you and the fund and there is basically no latitude to negotiate - there are many vesting provisions, forfeiture provisions, buyout provisions, and basically all sorts of bells and whistles to not pay out carry if you're not at that fund - either because you wanted to leave or they kick you out.
So TLDR - funds are only in carry if they (i) perform very strongly (2.5x deal-level MOICs), and (ii) perform incredibly consistently across long-periods of time (10+ years). Funds with very high velocity and lucky (e.g., raise a fund, deploy, and sell in the same macro-cycle) have a much better chance of realizing carry. Funds that need to perform across long-periods of time in constantly changing macro-economic (fiscal, monetary), geopolitical, and technologically disruptive environments - much much harder to generate and crystallize carry (how many people can make any sort of prediction over 5-10-year time horizons on these dimensions? and how many people who are good investing in "choppy" environments are good at investing in "good" environments?).
feel free to add your perspectives
Based on the most helpful WSO content, here are detailed reasons why carry is hard to realize in practice:
Carry is Calculated Off Fund-Level IRR
Carry is Calculated Off Fund-Level Net IRR
Carry is Subject to a Preferred Hurdle Rate for the LP
Time & Claw-Backs
You Need to Be in the Seat to Realize Carry
Summary: - Funds need to perform very strongly and consistently over long periods (10+ years) to realize carry. - High-velocity funds that can raise, deploy, and sell within the same macro-cycle have a better chance of realizing carry. - Funds that need to perform across varying macro-economic, geopolitical, and technological environments face greater challenges in generating and crystallizing carry.
Feel free to add your perspectives!
Sources: Actually Realizing Carry, Actually Realizing Carry, Confused about carry at PE Fund, Carry in REPE, Is PE worth it? Can someone explain how carry works (BPS, etc)
Work at an LP.
A couple of comments and clarifications:
For point 2: Your description is circuitous, since mention that carry is after net returns, which already includes impact of carry. But it is true that carry does come out after fees/expenses (likely 2.5-3.0% in total), so gross returns likely need to be above 10.5% for the GP to see a dollar of carry.
For point 3: This is somewhat pedantic, but in a 100% catch-up structure, which is probably the most common in PE (but less so in other asset classes), a GP can earn a full 20% share of the profits at exactly 8% net IRR. In 20/80 or 50/50 splits it can take a few percent higher net returns to achieve a full 20% profit allocation, but the GP is getting something along the way.
For point 4: Basically all clawbacks these days are net of taxes paid, which does soften the blow in terms of returning money (but if it's liquid it can still be a problem). I think this will be a bigger issue for LPs in the next few years as funds drag on with an asset or two that are likely valued too aggressively.
One other comment is that in older funds, GP benefitted from a subscription line that was cheaper (say S+350 with close to zero rates) than the preferred return (pretty standard at 8%), which pretty mechanically boosted LP IRRs. With sub lines now similar or slightly higher in cost than the pref (which one could argue is too low today given cash returns), the free few points of net IRR accretion is gone.
This is a fantastic response and what I was thinking when I read the original post. There are certainly challenges to realizing carry, but you really only need to achieve a 12% - 13% gross IRR in order to pay out carry at the often quoted 2.0x return level (depending on the amount of fund level expenses).
Subline rates is true but in credit Funds you are now seeing an increase in the base rate as well. A few years ago base rate was lower than single digits and now it’s closer to 5%. Financing costs are up but so are the rates you’re charging.
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