VC Primer: The Carry

I have been waiting for something interesting in the news before I posted for the first time about buyouts. The Deal has reported an interesting story about Bain Capital and its 30% carry being a contentious issue with LPs during its fundraising. So my first post about buyouts happens to be a great VC Primer as well - The Carry.

What exactly is “The Carry”? This is the percentage charged as an incentive fee on profits. Some people refer to it as the “incentive allocation”. What it amounts to is the percentage of the profit that goes to the fund managers. Given the potential for outsized gains in the venture and buyout category, the carry necessarily incentivizes the general partners to go for big wins.

Typically the carry should vary appropriately to the quality of the fund. I have seen carries as high as 40% on a superstar fund and as low as a few percent on a fund of funds. There used to be a general rule that if you were an investor looking for funds, typically to stay away from funds with a lower carry. The standard ranges from 20 to 30 percent but this can also vary by the demand of “access” into the fund. In the go go days of the internet boom, there were several first time funds with hefty carries. In contrast, in recent years the carry has been more reasonable. I personally think it is silly to evaluate a fund based on the carry but then again the carry usually is associated with past performance.

Now for a buyout fund the industry standard is 20%. The issue being raised by some of Bain Capital's LPs is that a 30% carry is unjustified for a few reasons. First, everyone else is charging 20%. Second, many of Bain's deals are club deals in which other firms are coinvesting. Those other firms are charging a 20% carry for essentially the same investment as Bain. Apparently Bain has felt the need to justify their carry based on their track record and large research staff through a letter to investors.

A crude example of a 20% carry on a $10 million commitment to a fund where the total capital commitment was called would be that once the investor is paid back his original $10 mm the rest of the profits are split 80% to the investor and 20% to the fund. If the fund makes 3x on its fund then the carry would amount to $4 mm paid by the investor. If you imagine that the carry is paid by every investor, you can see how lucrative it can be for the fund to have big wins.

Now, the above example is simplified. There is usually a “hurdle” or “preferred return” involved. Also, the fund will charge a management fee as well. I will post on these two topics later. What I will say for now is that I don't believe in the hurdle, I don't believe in high management fees, but I do believe in substantial carries. The venture investor should get paid for large gains and the best incentive is to get paid from the back end proceeds rather than upfront or along the way.

Comments

[Andrew Fife]

I agree, the best way to motivate is to align interests and backload as much compensation until after the investors goals have been met. I'm curious to read you analysis of management fees. Thanks for the interesting post!

[RG]

Thanks for an interesting post. From my read of carry, the fund managers are effectively incentivised to swing for the fences - they get a substantial share of the upside with no downside risk. (They are granting themselves a free call option at the cost of the investors. I would have thought this assymetric incentive system would encourage excessive risk taking (just like we saw at the height of the boom.) I'd be interested on your thoughts on this.