What is 'carried interest' in the context of private equity?

Carried interest refers specifically to the share of profits that general partners in a private equity fund receive after the fund has achieved a certain predefined performance benchmark, often referred to as a "hurdle rate." This mechanism serves as an incentive for the fund managers to maximize returns for their investors, as they only receive this portion of profits after surpassing the agreed-upon return threshold.

This concept aligns the interests of the general partners with those of the limited partners: both parties benefit more as the fund performs better. Carried interest typically represents a significant portion of the profits, often around 20%, which can result in substantial earnings for the general partners if the fund performs well. This structure encourages active management and alignment of priorities between the investment team and the investors.

The other options do not capture the essence of carried interest accurately. For instance, the initial investment made by general partners refers to capital contributions rather than profit sharing. A fixed salary, while part of a general partner’s compensation, does not vary with performance and is distinct from contingent earnings like carried interest. Finally, the costs associated with managing a fund relate to operational expenses rather than profit-sharing elements intrinsic to carried interest.