Being an aspiring commercial lawyer often means being confronted by complex, often abstract, concepts leading to an often impenetrable wall of jargon for students and trainees. Next up in our LegalLingo series, which we've introduced to help break down this jargon, is an explanation of carried interest.

Keep calm and carry on

Carried interest - or 'incentive fee', 'performance fee' or 'carry' - is a method of compensation received by individual fund managers (i.e. executives) in private fund or hedge fund structures.

These executives receive a share of the profits generated by the realisation of the fund's investments in portfolio companies. It is typically paid to the carried interest recipients at a rate of 20% of the fund's profits (with 80% paid to the fund's investors). However, carried interest is generally only paid after the fund returns the initial capital investors put into the fund plus a certain minimum return (known as the preferred return or hurdle rate) to investors.

Therefore, the level of carried interest paid to executives is derived from the performance of the underlying investments and the amount (if any) is not guaranteed. It aligns the interests of the executives with the performance of the fund and creates an additional incentive to maximise the fund's returns for investors.

Typically, the amounts of carried interest paid to executives is also subject to other restrictions. For example, if the fund fails to meet a certain level of return or an unforeseen liability arises, any overpayment of carried interest previously paid to the executives could be required to be repaid back to the fund and paid to investors via a process known as 'clawback' to ensure that no more than 20% of the profits have been paid as carry.

Most fund managers also charge a management fee (typically of around 1.5 - 2% per annum of an investor's commitment). However, unlike carried interest, the management fee is not dependent on fund performance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.