PE - Carrying Interest and the State of Private Equity - exponential wealth generation

For anyone well acquainted with private equity compensation, the idea of carrying interest will come with no surprise to the allure of how employers provide you with an attractive prospect of committing more of your time to growth, within the context of the role, while trading away more of your time. Trading time for growth, whether it be for status or money, is a topic discussed a lot here in the Oasis. However, there is a silent majority that likely hasn't explored the intricacies of carrying interest within PE and would maybe like to learn more about the topic in general. 

At first glance, carrying interest is a mechanism for profit sharing employers can bestow to employees at the firm that will vest over the lifetime of the underlying investment. An example commonly looks as follows: You close $50mm deal for firm -> as a VP/MD you get awarded a percentage of the carry of the deal -> this amount vests in excess of the hurdle rate over the lifetime of the investment -> you take home a lofty lump-sum taxed at right around 20%, excluding the salary from your employer you would collect in the prior years. What needs little explaining to all you young batemans and axelrods, is that if you investment doesn't clear your expected values and your IRR hurdle isn't met then the carrying interest owed to you is worth a whopping $0.00 (or roughly 4 Zimbabwean dollars, give or take a few basis points). 

An attractive prospect, especially for firms where carrying interest is awarded at a VP level and onwards, however, consider that it's usually the General Partners (GP) that get awarded larger carrying interest rates relative to senior staff. Ballpark for VP/MD carrying interest in private equity ranges between 0.25% to 2.00% from what I've gathered. Disclaimer is that I've struggled to find good, reliable, rates for carrying interest online, so I provided a range of numbers I've seen in the space a few times, in addition to being conservative with my estimates. GP carrying interest figures are usually significantly higher than VP/MD percentages, to at least 2 standard deviations. 

While the mechanism of carrying interest + salary compensation is attractive to those looking at breaking into the private equity space, what is being brought to my attention is the idea that the days of financial engineering for large gains are dawning their end. While alternative assets have remained a strong asset class for investors looking to diversify, and historically being awarded a disproportionate level of reward relative to risk, favoring the upside, it seems that the universe's tenacity towards mean reversion implies that even the fabled lands of private equity are not free from correction. The returns in the space have tapered in recent years and it is no doubt harder to gain stronger returns relative to the market now than before. Likely specialization will become the defining trait for successful firms in the space going forward.

I want to create a longer & more refined variant of this post, but for now wanted to share my unfiltered thoughts, as well as open to discussion and questions you guys might have here in the Oasis that would be interesting to explore further.


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