The venture capital community is not the most inclusive, and new investors might find it hard to scout for the proper connections that would get them on the right track. Venture ecosystems such as Diffuse aim to help them build such connections, for a small price.
And that price is carried interest, a small amount that investors have to pay the ecosystem for the management of a fund. But here’s the thing: Carried interest is only created when the investor gets returns on an investment.
If you’re an investor new to the game and/or looking to join a venture ecosystem such as Diffuse, this will help you better understand the concept of a carried interest.
What is Carried Interest?
Carried interest, often referred to as the “carry” is a percentage of the profits gained from an investment that exceeds the amount contributed by a general partner to the successful partnership between an investor and an investee.
Carried interest is the compensation received by the general partner (usually an organization of investment managers that contributes anywhere from 1% to 5% of the fund’s initial capital) for managing a fund and making an investment happen. Carry can be paid over a set time period such as five years. An ongoing management fee is also paid to the general partner in the lead-up to a successful partnership.
Naturally, general partners will have a vested interest in the fund gaining profit from the beginning, when it hands in its investment in the fund. They also usually receive an annual management fee, often around 2% of assets.
Carried interest is seen by the law as capital gains and is therefore taxed at preferential capital gains rates. This is because general partners are regarded as organizations similar to enterprises, which treat portions of their returns from their business as capital gains, not exclusively as wages and salary.
However, general partners argue that they should be taxed in the same fashion as investment bankers. Bankers receive their compensation as wages, including the portion that is tied to a bonus system. This portion of their compensation is taxed at ordinary income tax rates.
How it Works
Let’s apply this to real-world scenarios:
In this hypothetical situation, an individual invests $100 thousand and pays a total of 20% carried interest to the Diffuse ecosystem. There are three outcomes that can be expected of this investment.
#1. In the first hypothetical outcome, the investor gets its invested $100 thousand in return.
In this case, the Diffuse ecosystem gets $0. This is because carry is only created when the fund generates profits. The investor only received the exact amount that is invested and no profits are gained, therefore the general partner gains nothing. This is called a break-even.
#2. In the second hypothetical outcome, the investor gets 10x its investment in return.
In this case, the investor gets total exit event proceeds in the amount of $1 million from its original investment of $100 thousand.
If the fund generates a total profit of $4.5 million, then the carry to be paid to the Diffuse ecosystem will be $180 thousand. Total Investor proceeds will then be at $820 thousand, out of the $100 million it received in return.
#3. In the third hypothetical outcome, the company receiving the investment fails.
In this worst-case scenario, the Investor loses his invested $100 thousand. Consequently, the Diffuse ecosystem gets $0.
Why it Matters to You
Carried interest works to an investor’s advantage because it eliminates the risk of failure associated with early stage investing. If returns don’t pan out from an investment, the investor won’t have much to lose from a general partner.
On the other hand, the investor will have all to gain from connecting with a general partner. Hence, a carried interest results in an almost ideal scenario for any investor looking to get its hands on a private equity fund or a hedge fund.
For better or for worse, Investors need to weigh the potential cost against the assumed benefits they see in the fund, including the general partner’s expertise and what they can contribute to it. Investors need to consider whether or not general partners can add enough value to the fund to justify the carried interest that they could potentially earn.
In many ways, investors can see carried interest as a better deal compared to paying a more short-sighted upfront commission charged by broker-dealers. And that’s exactly what the Diffuse ecosystem offers: a low-risk, friction-free alternative to finding and managing a worthwhile investment.
Join the ecosystem and become a Lead Investor here.