Carried Interest
Also written Carry
The manager's share of an AIF's profits above the hurdle rate — called additional return in Indian AIF documents — customarily 20% in the global "2-20" model and usually paid on exits.
In plain language
Managers of private funds earn two kinds of pay. The management fee is paid whether or not the fund makes money. Carried interest — "carry" — is paid only if the fund does well.
The workbook explains that additional returns (known as carried interest or simply carry in international markets) are sometimes given to the investment manager as an incentive to outperform the hurdle rate, maximising what investors in the AIF receive.
In developed markets, private equity funds have customarily been structured as "2-20": a 2% management fee and 20% additional return. The workbook is clear that additional returns and the 2-20 structure are not a standard feature in the evolving Indian AIF market. Whether carry is paid at all, and how much, depends on the sponsor or manager's credibility and track record, the type of fund, the scheme's focus and the size of the corpus.
How it works
When it is paid. AIFs are illiquid and their investments cannot be reliably valued until exited. So, while a fee on AUM may be linked to estimated NAV, additional returns (if agreed) become payable only upon liquidation of the fund in a closed-ended structure and are normally assessed on exits. In India, additional returns may be paid on a staggered basis depending on performance.
How it is computed — the fund terms specify:
- whether carry is calculated deal by deal or on the aggregate portfolio;
- whether there is a catch-up, making the manager's additional return a percentage of the fund's total return rather than only of the return above the hurdle;
- whether a high watermark applies — more common in hedge funds — so the manager earns additional return only on value above the highest level previously recorded.
Where it sits in the waterfall. After expenses, reserves, fees, return of capital and preferred return; then catch-up (if any); then the residual split. Carry holders commonly hold Class B units, investors Class A.
Super carry. Highly sought-after funds with a very high return track record may negotiate a higher carry — "super carry". The workbook notes this can suit investors if negotiated in lieu of a higher management fee. It also notes that hard negotiation by investors is driving down fees and making super carry and catch-up clauses harder for managers to obtain.
Alignment and disclosure. Carry terms, including super carry after a higher preferred return, are among the main alignment-of-interest areas investors examine in due diligence, and the PPM's executive summary must disclose the proposed additional return or carried interest.
A worked example
Illustrative figures from the workbook's worked case (representative only). The Alpha Fund has Rs 2,000 crore paid in, a 10% hurdle, 20% carry and a 25% catch-up to the manager. In its final year (Y8), distributable cash after fees and expenses is Rs 6,840 crore, of which Rs 1,460 crore is needed to bring investors to their 10% hurdle.
Distributable cash in Y8 Rs 6,840 crore
Less: to investors for hurdle and capital Rs 1,460 crore
Balance Rs 5,380 crore
Catch-up to manager: 25% x 5,380 Rs 1,345 crore
Residual Rs 4,035 crore
Investors' further return: 80% x 4,035 Rs 3,228 crore
Carried interest: 20% x 4,035 Rs 807 crore
Manager's catch-up + carry Rs 2,152 crore
Investors' total Y8 distribution (1,460 + 3,228) Rs 4,688 crore
The fund's net FIRR is 24.56%, but because Rs 2,152 crore goes to the manager as catch-up and carry, the investor-level FIRR falls to 20.13%.
For Mr Sethi, an investor holding 1% of the units, that is the difference between what the fund reports and what he actually earns — and it is exactly the gap the workbook tells distributors to explain before he signs.
Why NISM asks about it
Chapter 3 (Concepts in Alternative Investment Funds Industry) introduces additional returns and carried interest at 3.8, the 2-20 model and high watermark, and places carry in the waterfall at 3.9 and Table 3.1. Chapter 6 (Risk and Return — Investor and Fund Perspective) computes catch-up and carry in Step 10 of the worked case at 6.8, and Chapter 8 lists carry and super carry among alignment-of-interest areas. Expect questions on when carry is paid, on the catch-up, and on why investor-level IRR is lower than fund-level net IRR.
Common exam traps
- In Indian AIF documents the term is "additional return"; carried interest and carry are the international names for the same thing.
- 2-20 is the developed-market custom, not an Indian standard. The workbook says it is not a standard feature here.
- Carry is earned above the hurdle rate; the management fee is paid regardless of performance.
- Carry is normally assessed on exits and paid on liquidation in a closed-ended fund — though Indian AIFs may stagger it.
- Deal-by-deal versus aggregate portfolio is a term of the fund; so is catch-up. Neither is fixed by SEBI.
- Super carry is a higher carry for top-performing funds, and the workbook notes it may benefit investors if it replaces a higher management fee.
- Investor-level IRR is below fund net IRR once carry is paid — 20.13% against 24.56% in the worked case.
Check yourself
1.One of the key disclosures in a PPM is:
- a)the amount of investment made by the investor
- b)the management fee structure
- c)the details of asset securities
- d)the minimum guaranteed return
Show the answer
Answer: (b) the management fee structure
This is the workbook's own sample question. Section I of SEBI's template requires proposed management fee details, preferred return (Hurdle rate) as proposed in IRR terms or any other method, additional return or carried interest as proposed, expenses structure, distribution waterfall for each class of units, and Section XII requires a full Illustration of Fees, Expenses and Other Charges. Option (a) cannot appear because the PPM is written before any investor commits, and individual terms live in the contribution agreement, which is generally not shared with other Contributors. Option (d) is impossible — an AIF is not an assured return product.
2.The fair value of an individual investor's interest in an AIF is:
- a)the fund's bottom-up NAV multiplied by the investor's percentage of units
- b)the proportionate distributable NAV after deducting taxes and statutory payments, outstanding fees and expenses, carried interest and other contractual deductions
- c)the investor's paid-in capital plus accrued hurdle rate
- d)the aggregate cost of the fund's investments divided by units outstanding
Show the answer
Answer: (b) the proportionate distributable NAV after deducting taxes and statutory payments, outstanding fees and expenses, carried interest and other contractual deductions
The fund's NAV is built bottom-up — NAV (Fair value) of a fund is equivalent to the sum of the estimated fair value of underlying portfolio investments of the AIF as on the valuation date. This type of valuation is known as the 'sum of parts valuation' method and in AIF parlance, it is known as the 'bottom-up approach'. But the investor's share is not a simple fraction of it: the fair value of an investor interest would be equal to the proportionate distributable NAV of the fund as of that date after deducting taxes and statutory payments if any, outstanding fees and expenses, carried interest and other contractual deductions. The result is the Adjusted NAV — equivalent to the amount of cash that would be received by the investors as if all underlying portfolio of investee assets were realised as at the valuation date.
Where this is taught
Free preparation for NISM Series XIX-ARelated terms
- Hurdle rateThe minimum return that must accrue to investors before the manager earns any incentive fee — the threshold that turns a fund's profit into the manager's profit.
- ClawbackAn investor right to recover carried interest already paid to the manager on early successful exits, when later failed investments mean the manager was overpaid across the fund's whole life.
- European WaterfallA distribution sequence that returns 100% of investors' invested capital pro rata, then their full preferred return, before the manager receives any additional return or carry.
- High-Water MarkThe highest year-end NAV the fund has ever reached, net of operating, transaction and management costs — the manager earns no incentive fee until the NAV climbs back above it.
- Management FeeThe fixed annual fee an AIF pays its investment manager for managing the fund — charged on committed capital in Category I and II funds and on gross NAV in Category III, regardless of performance.
- Catch up clauseThe waterfall step that pays the manager a set share — often 100% — of the profit left after investors receive their capital and hurdle, until the manager reaches its agreed share of total profit.
- Deal-by-deal distribution waterfallThe order in which a close-ended Category I or II AIF pays out the proceeds of each individual exit — expenses first, investors next, the manager last and only what is left.
- Lead InvestorThe investor who sources a deal, does the diligence, commits their own capital and then assembles a syndicate of accredited investors to fund the rest — usually for a fee or a share of carry.
- SyndicateA structure in which many smaller investors pool money in a special purpose vehicle to invest alongside a Lead Investor, who does the due diligence, commits own capital and charges a fee or carry.
- Pro-rata rightsThe rule that each AIF investor's share in every investment of a scheme, and in the proceeds, follows their share of commitments — save for excused, excluded or defaulting investors and the manager's carry.
- Adjusted NAVThe value of an AIF measured as the cash investors would receive if every portfolio investment were realised at fair value on the valuation date, after taxes, fees, expenses, carry and other deductions.
- GivebackA distribution-waterfall clause where investors agree to return part of what they already received, to cover a liability surfacing after distribution — an alternative to a fund reserve.
- Super CarryAdditional return (carry) charged by a highly sought-after AIF manager above the industry-norm "2 and 20" benchmark, reflecting strong negotiating power from a high performance track record.
- Self-managed FundAn international fund model in which the investment team are employees of the fund itself and draw their salaries and costs from the fund, so the headline management fee is lower than a normally managed fund's.
- Target ReturnThe return a manager says it intends to achieve from a scheme — a statement of ambition that signals how much risk it plans to take, never a promise and never the contractual carry threshold.