Private Equity 20 Lectures（17）Carried Interest Fancy Full Explanation From the story of the shipowner and the captain of the ship

Private Equity 20 Lectures, Silicon Valley Investors' Legal Essentials, I am American lawyer Liu Xiaoxiao.

If you know anything about private equity, you must know the concept of Carried Interest, and sometimes we even call it Carry for short, but have you ever felt that this word is a bit strange and the translation is very awkward? So where does the name Carried Interest come from? What are the advantages and disadvantages of Deal by Deal Carry and Back-End-Loaded Carry? And what causes a general partner (GP) to clawback? Today we'll dissect the concept of Carried Interest.

We take limited liability for granted, but before the first Limited Liability Company Law was enacted in New York State in 1811, companies operated with unlimited liability, which led to the fact that only family members and friends who knew the company well could invest in a company, and outsiders were unlikely to dare to invest in a company. The shipping business is a form of business that is most similar to the limited liability system in practice before there is a limited liability company system guaranteed by law. Because the ship from the sea to reach the other side of the intermediate process is a relatively closed space. A ship to the sea, only three situations, the first is successful to arrive at the other side, we can sell goods and share the money; the second is the ship sank, blood money; the third is the ship encountered pirate attacks or the crew of the theft, because the environment is relatively closed, this situation is also very easy to find and pursue responsibility.

Then this kind of environment makes outsiders more assured, so the voyage marine transportation has become the earliest testing ground for venture capital.

The shipowner in the age of navigation is similar to the limited partner (LP) in the private equity fund, that is, the person who pays the money, and the captain is similar to the general partner (GP) in the private equity fund, that is, the person who pays the effort. The shipowner buys a shipload of cargo, but they don't want to risk their lives to make the trip. So the captain becomes the risk taker. Regardless of how much hardship or smooth sailing is experienced along the way, the captain will automatically receive 20% of the total value of the goods they ultimately bring to the Old World from the New World, which in English is "20% commission on the things they carried", which is the origin of the Carried Interest. This is the origin of Carried Interest.

1. Deal-by-deal Carry

Let's look at Deal-by-deal Carry, which is a classic model for early stage funds where the General Partner (GP) gets 20% of the proceeds from successful deals, regardless of failed deals.

This model is not common in Blind Pool funds, what do you mean by Blind Pool? Now we see most of the funds can belong to the blind pool fund (Blind Pool), that is to say, a fund will invest in a lot of different portfolios (Portfolio), to the current market common fund, usually a fund can invest in about 30 portfolios (Portfolio), the general partner (GP) can be independently with the portfolio (Portfolio), that is to say, has already been the case. (Portfolio), that is to say, has given the general partner (GP) a great deal of discretion, in this case the use of liquidation by liquidation of the incidental gains (Deal-by-deal Carry) is obviously unfair to the limited partners (LP).

So under what circumstances would such a calculation be used? I don't know if you have heard of a concept called Case Fund, what does it mean? The main reason is that this word is not too easy to translate, it should be said that a fund invests in a project, and the limited partners (LP) can decide whether to participate in a transaction, which means that the limited partners (LP) actually have the opportunity to choose before each investment decision in the fund. This is in fact similar to the business model of the age of navigation, I'm sailing on this ship of goods, sailing conditions will affect the safety of the entire ship of goods, rather than that divided into different routes to run, or a few ships sailing, there are gains and losses, then in this case, so that the loss can not be blamed on the general partner (GP).

2. Deal-by-Deal with Loss Carryforward Carry

For most of the funds nowadays, it is obvious that the above liquidation-by-deal carry can not be used, so later on the development of liquidation-by-deal with loss carryforward carry (Deal-by-Deal with Loss Carryforward Carry). We pay attention to this place two Carry, the first carry is Carryforward (Carryforward) inside the verb, the second carry is a shortened version of the incidental income (Carried Interest).

As the name suggests, Deal-by-Deal with Loss Carryforward Carry (Deal-by-Deal with Loss Carryforward Carry) will take into account the loss caused by the failed transaction when distributing the proceeds, so accordingly, if the previous project made a lot of money, and the project behind the blood loss, then the general partner (GP) will need to be the previous project to make more money back. back. This is why there will be a clawback (Clawback), you can imagine, if a fund has 30 portfolios (Portfolio), then to calculate many times the clawback (Clawback), and pay attention to this one by one liquidation of the loss carryforward with loss Carryforward Carry) is also a four-step waterfall (Waterfall), you can imagine each portfolio (Portfolio) exit are in accordance with the four-step waterfall (Waterfall) were calculated in accordance with the loss Carryforward (Loss Carryforward), then how many intermediate dial back (Clawback), the calculation is how complex it is. How complicated is the calculation?

3. Back-End-Loaded Carry

Said so half a day finally came to most of the funds we see today using the distribution method, that is, the back-end loading incidental income (Back-End-Loaded Carry), I know that this translation is particularly awkward, but there is no way to put up with it, if not, it will be a little bit distorted.

The core of this Back-End-Loaded Carry is that it does not allow the general partner (GP) to get the income distribution from each investment allocation, but requires the limited partner (LP) to get back the principal and all the preferred return (Preferred Return) before the general partner (GP) can get the income distribution. In fact, this is also a four-step waterfall (Waterfall) model, except that it is calculated according to the entire fund as a whole rather than according to the individual project exit to calculate.

So we can think about this situation, whether there is still a clawback (Clawback)? The answer is that there is still a Clawback. Why? A fund invested in 30 portfolios (Portfolio), of which the first 10 are wildly profitable, the first step of the four-step waterfall (Waterfall) in the first step of the return of capital (first of all the principal back to the limited partners LP), the second step to protect the eight (will be 8% interest to the limited partners LP), the third step to catch up (Catch-up) have been completed, has come to the last step of the The two-eighths, and the general partner (GP) is also in the two-eighths to make a lot of money. As a result, the back 20 projects are blood loss. So isn't there a clawback? So as long as it is a four-step waterfall (Waterfall) in the benefits to the limited partners (LP) in the first few projects in the share of the end, then even the Back-End-Loaded Carry (Back-End-Loaded Carry) type of fund is also going to have a callback (Clawback). In addition, even if the difference between the profit and loss of the project exited in the early stage and the project exited in the late stage is not big, there will be some expenses that need to be paid attention to in the last few years of the fund to be settled, for example, due to the exit of the project is often in the last few years of the fund intensively occurs, the attorney's fee, the accountant's fee in the last few years of the fund become more, it will lead to the last few years of the fund's efficiency is not as good as in the first few years of the fund, the general partner (GP) Clawbacks are inevitable.

So clawbacks are not completely unavoidable in a Back-End-Loaded Carry type of fund, they are just minimized.

Private Equity 20 Lectures, Silicon Valley Investors' Legal Essentials, I'm U.S. Attorney Xiaoxiao Liu.