Carried Interest Participant Allocation Plans: The Current State of the Market and Controls for Managing Carried Interest Data

Ryan Burger, Vice President

Private equity and other private capital firms – including private debt, venture capital, real estate, infrastructure, and hedge funds – are turning their attention to the compensation function to enhance controls and efficiencies using software solutions. In recent years these organizations have been optimizing their internal operations by making better use of technology by implementing new solutions. However, until recently, most firms did not automate processes within the compensation function, as the majority focused on other areas requiring improved use of systems as a priority, including fund accounting, corporate accounting, portfolio monitoring, and investor relations. There is now a growing trend to leverage software platforms and service providers to reduce the reliance on spreadsheets and improve controls and reporting. Many firms are now deploying software which is resulting in a richer experience for employees (i.e., statements and dashboards), mitigation of risks in calculation mistakes, as well as creating the ability to generate firm level analytics on compensation (including diversity and gender pay gap analyses).

The compensation function involves the management of highly sensitive data (as with most organizations) and calculations and reporting can be prone to user error given the reliance on spreadsheets. In private markets, the compensation function includes management of staff members’ wages, bonuses, equity in the management company, carried interest allocations, retirement contributions, and other compensation arrangements.

One such compensation arrangement that often includes many interdependencies and is a major element of private capital compensation is carried interest. Carried interest, or ‘carry plans’, are opportunities for employees and partners to share in the financial success of a private equity firm’s profits, often acting as an incentive and aligning employees, partners, and affiliates with the firm’s success. These carry plans dictate the proportion of profits that individuals or entities will receive upon successful investing and often have stipulations based on seniority, role, tenure, and many other factors.

This article provides an overview of various types of carry plans and complexities, including current industry trends and best practices to help manage this sensitive and essential data.

Current State of the Market

Many firms maintain strict control over their compensation processes by limiting the number of individuals with access to highly confidential carry and compensation data. As more funds are launched within a firm, and partners and employees join and leave, the operational activities and data management efforts begin to increase significantly.

Most organisations rely on spreadsheet models to handle carry and compensation arrangements to track and report on all employee, partner, and affiliates’ share of past and future carried interest and other compensation arrangements. These models track employee carried interest allocations, including former employee awards, vesting schedules, past distribution data, and future forecasts. Effective management of this data is critical, so the calculation remains correct and partner/employee compensation is not miscalculated.

In addition to common key person dependencies and increased complexities, additional internal compensation reporting needs are evolving, paralleling overall industry advancements, such as improved investment/portfolio company analytics and transparency to external investors (i.e., limited partners). Thus, firms are increasingly seeking ways to aggregate compensation data across the enterprise, to view and report on salary details, bonuses, retirement contributions, carried interest awards, management company income, and equity investments by partners/employees—all in a single view. Firms are also using this data for year-end budgeting, forecasting, and fairness of pay initiatives, such as diversity and gender pay gap analyses.

Section 1: Overview of Carry Management Plans

1. Types of Carry Plans

Carry and incentive plans vary significantly across the alternative investment industry to effectively award employees, partners, and affiliates for the efforts that they contribute to their organizations. Firms may structure their carry plans to allocate participant award percentages at various levels (e.g., by fund, by investment or investment tranche, or by vintage year for each fund and/or deal).

The major types of carry plans are outlined here, and each firm determines the appropriate model that offers the greatest benefits for their organization to effectively reward team members.

As illustrated in Exhibit 1, carry participants (i.e., employees, partners, and affiliates) receive a pre-defined percentage (or points) which dictates the proportion of profits they are entitled to, should the fund invest successfully and generate carried interest revenue. A proportion of the overall carry percentage will remain unallocated for a specific length of time, to allow the company to provide incentives to new team members, as well as to increase incentives to existing staff as the fund grows.

1a. Fund Level Model

Fund level awards are used by firms which allocate carry percentages (or points) by fund. The purpose of this model is to incentivize based on the overall success of the fund, instead of the individual investment performance within the fund. The first example in Exhibit 1 illustrates how partners/employees have carry percentages or points allocated for each fund the firm manages. The individuals with points in this fund receive proceeds based on the overall success of the fund, regardless of specific investment performance.

This model is often used by firms that have a high volume of investments or high volume of trading activity, such as credit oriented funds. However, this model can also be used by traditional buyout private equity and venture capital firms, too.

Example: Fund Level Allocations

As illustrated in Exhibit 1a, Sue Gill has a 10% carry allocation to Blue Skies Fund 1. If Blue Skies has been successful and can pay General Partner (‘GP’) Carry profits to carry participants, Sue Gill will receive 10% of these profits (e.g., $100,000 of $1,000,000 in carry). Sue Gill gets paid based on the overall success of the Blue Skies Funds, even if certain investments are not as profitable as others. As illustrated in Exhibit 1a, Sue and her colleague’s allocations can be identical or different across funds.

1b. Investment Level (and Investment Tranche Level) Model

Investment level carry allocations, also referred to as deal-by-deal allocations, are often used to award employees, partners, and affiliates for their individual participation on specific deals or investments, where they may be the lead investment professional involved in sourcing the deal or provide other business contributions to a specific investment (or being employed during the time of successful investments).

This is not to be confused with deal-by-deal carry arrangements at the fund level, though the two may be utilised concurrently, the purpose of this model is to award carry participants based on the individual success of investments.

Additionally, some firms will award carry based on funding rounds of the same investment at different points in time (often referred to as tranches). The deal-by-deal example in Exhibit 1b shows GP member allocations/points at the investment or portfolio company level, and tranche-by tranche level follows the same methodology except participant allocations are established by investment funding round within the same investment.

Example: Investment Level Allocations

Exhibit 1b provides an example with individuals receiving carry awards by each individual investment or deal.

Suppose Sue Gill has an 8% carry allocation to the Acme Construction investment in Blue Skies Fund 1 and a 5% carry allocation to Fast Jet Airlines in Blue Skies Fund 1. If Blue Skies Fund 1 has been successful and can pay out GP Carry profits for both investments, Sue Gill will receive 8% of the profits from Acme Construction and 5% of the profits from Fast Jet Airlines. In this scenario Sue Gill gets paid out based on the individual success of these two investments.

As depicted in the Exhibit 1b, Sue will receive the same allocation percentages in the two investments in Blue Skies Fund 2, so she will receive the same percentage (i.e., 12%) of the GP Carry distributed for this fund (i.e., 12% from Green Acres Landscaping investment and Agile Tech Solutions investment).

1c. Vintage Shares and Hybrid/ Dynamic Models

Allocations by vintage year is used by firms that choose to establish carry award for each financial year. The purpose of this model is to allow a firm to revisit each individual team members value to the firm on an annual basis and determine whether carry allocations should be adjusted or remain unchanged.

Firms that use the vintage share concept will use yearly points allocations in conjunction with the fund and investment level carry allocation models.

For example, the allocations used for investments made in a specific year will automatically use the participants carry percentages in that year for the fund making the investment. Firms may keep vintage share allocations consistent across funds or can be specific by fund, as is illustrated in the example below.

Example: Vintage Share Allocations/ Fund-by-Fund Allocations

As depicted in Exhibit 1c, Sue Gill has future carry awards in both Blue Skies Fund I and Blue Skies Fund II in vintage years 2019 and 2020, in which her allocations vary between these two funds across both vintage years.

For investments made in 2019 in Blue Skies Fund I, she receives a 5% allocation and for investments made in 2019 Blue Skies Fund II, she receives 8% in carry. Since one investment was made in 2019 in Blue Skies Fund 1, she receives 5% of future carry for this investment (i.e., Acme Construction). There are two investments made through Blue Skies Fund I in 2020, so she will receive 12% allocation to these investments (i.e., Fast Jet Airlines and Smooth Ride Bikes).

In this scenario, Sue Gill is awarded based on the individual success of each investment and the percentage of her carry is dependent on the fund and the vintage year that each investment is made.

As depicted in Exhibit 1c, there have not been any investments made in 2020 in Blue Skies Fund II, therefore no future carry awards are attributed to any of the participants for this vintage year and fund. When or if investments are made (i.e., capital deployed) in 2020 for Blue Skies Fund II, Sue Gill will receive 14% carry awards to these investments.

2. Types of Vesting Schedules

Across the industry, participants’ carry awards include stipulations based on tenure at their firm to dictate how much a participant is eligible for, should they separate from the firm. These stipulations are known as ‘vesting schedules.’

As with many aspects of compensation, vesting arrangements are handled differently across the industry, as outlined below. Exhibit 2 illustrates how a 4-year vesting schedule can be constructed where individuals’ awards accrue on a yearly, quarterly, or monthly basis, and forfeit any accrued awards if they separate with the organisation prior to the 1st year.

Vesting schedules are linked to the level at which carry is granted to participants (see Exhibit 2a).

2a. Vesting Arrangements, Terms, and Cliffs

A common practice in private equity firms (and other AIFs) is to use a 20% per annum (or 5-year) vesting schedule with an initial one-year cliff (0% in year 1) with either yearly, quarterly, or monthly vesting thereafter – yearly being the common practice.

While 4-year and 5-year vesting schedules are common, some firms will vest a portion each year (i.e., 22.5% for 4 years), leaving 10% as unvested until the fund is fully liquidated, which allows the firm to maintain reserves. There are models where 70% vests over the first 3–5 years of the fund, with the remaining 30% vesting over the life of the fund or the investment. There are also rare models where vesting may not begin until year 4 and vest 20% each year thereafter.

As depicted in Exhibit 2b, Sue Gill is currently vested at 60% of her 5-year vesting schedule within Blue Skies Fund 1 as of 1/2/2020. The carry for Blue Skies Fund 1 is currently valued at $1,000,000. If the firm were to liquidate all investments, then Sue will be eligible for $60,000 based on her tenure, her percentage of carry, and the valuation of the fund.

2b. Forfeitures

Most vesting arrangements are based on fixed percentages (e.g., 20% per annum) as described above, however some firms will add or adjust accrued carry outside of the calculated standard vesting agreement upon an employee’s separation. For example, some firms have conditions to award or forfeit carry based on the performance of the employees (i.e., good leaver vs. bad leaver for-cause, where a bad leaver for-cause may experience additional forfeitures).

Forfeited carry from terminated employees can either be re-allocated to the reserve pool of unallocated carry or, in some cases, allocated to a pool of executive level employees. The reserve pool can be a tool for incentivising the investment team members to earn discretionary carry awards through the life of the fund. The forfeited carry allocated to the executive pool will most likely be split pro rata based on their existing percentages.

3. Reporting and Full Employee Compensation Reporting

Private equity firms (and other AIFs) are working diligently to provide enhanced insights to employees and partners on the carried interest for which they are eligible, as well as reporting on their overall compensation. Firms are now working to provide full compensation reporting so these individuals can have a consolidated view into base, bonus, carried interest awards, management company exposure, and co-investments. Exhibit 3a is an example of a compensation dashboard screen aggregating various types of compensation types for an individual. This aggregated reporting is also used as a retention tool where forecasts are included, to ensure employees understand the potential total future value of their compensation arrangements – allowing companies to improve their reporting as an initial step towards a better experience.

Organisations that allocate carry by deal will often produce Dollars at Work and Vested at Work reporting so employees can see their carry points by deal, and also have a view of their carry based on the winners and losers across the portfolio. Firms that allocate carry by fund can also create this level of reporting to provide transparency, even though carry is distributed at the fund level.

Many partners and employees have ownership interests in the management company entity, along with the trend of third-party companies taking minority interests in the fee generating entity. As companies evolve their analytics on employee all-in compensation reporting, firms are producing aggregated reporting to show employees their ownership stake along with projected future value.

The goal is to deliver comprehensive reporting to create a similar experience that employees and partners are used to seeing through their banking and investment statements, combined with both online and mobile accessibility.

It is important to note that the first step is moving away from a spreadsheet product, such as Excel, as the main data storage utility. Cross enterprise reporting is graphically illustrated in Exhibit 3 to show how various types of income can be aggregated to produce individual and firm level reporting through dashboards and tailored reports via software applications.

After a fund generates its waterfall calculation process, which is the computation to determine the amount of profit that can be distributed to limited partners (‘LPs’) and the GP (also referred to as the Carried Interest Partner(‘CIP’)), additional calculations are performed at the individual participant level within the GP/CIP entity (as Illustrated in Exhibit 3b).

Individual GP/CIP participants (employees, partners, and affiliates) will receive a certain share of the GP profits based on their predetermined carried interest allocations, which may be awarded at the vintage, fund, investment, or investment tranche level. This process is also referred to as a ‘distribution’; which is different from the fund level distribution, since this type of distribution is rendering payments to employees, partners, and affiliates that are carry participants of the GP/CIP entity within the fund.

During this participant level distribution process, firms may provide additional discretionary awards based on individual contributions and other factors to reward employees and partners if not all carry is accounted for (i.e., reserve, or unallocated buckets). Once each participant’s carry amount is calculated, there will be various adjustments applied for tax withholdings, escrow withholdings (typically 20–30%), loans (where applicable), prior tax advances (where applicable), and other adjustments. Exhibit 3c displays an example where PFA’s FirmView is used to manage the distribution economics and produce a distribution letter.

Distributions to carry participants can follow the waterfall distribution, or can have other triggers (e.g., no distributions until all tax advances are paid back, or distributions can even be transitioned as investments in subsequent funds).

4. Distribution Allocations

There are various approaches to allocate carry for distributions (to GP level carry participants – not fund level LP and CIP/GP distributions). Firms may distribute for single entities, multiple entities, or investments (including netting positive and negative balances across multiple investments).

As graphically illustrated in Exhibits 4a, 4b, and 4c, firms may distribute proceeds to carry holders or may distribute across multiple deals (winners and losers), or they may accumulate participant balances and distribute based on these balances.

For fixed distributions, these are based on participants’ GP share of each deal— recognising that participant award percentages change over time (joiners, leavers, promotions). To determine a weighted average of multiple deals, distributions are calculated/netted based on positive and negative balances and allocations. Please see Exhibits 4a, 4b, and 4c for these processes.

5. Minority Interests/External Firm Investments

There has recently been an increased emergence of specialized private equity firms and other institutional investors investing in the fee generating entities of alternative investment firms (i.e., management company and GP vehicles).

Typically, specific members of the general partnership entity are diluted in exchange for capital provided by the investing firm. Introducing 3rd parties provides fund managers with additional capital for growth and other purposes in exchange for equity, as well as strategic advisory and other support that the investor may provide.

From an operational perspective, additional calculations and reporting are required to account for the additional participant(s) and dilution of existing participant(s). Exhibit 5a illustrates the traditional model where employees, partners, and other affiliates are GP Carry participants, and Exhibit 5b illustrates the model where additional 3rd party investor(s) receive carry allocations.

“The future of private fund compensation reporting is to provide the same look and feel of commercial banking and investment statements with mobile and online access.”

Section II: Controls for Managing Carry and Compensation Data

Because of the sensitivity of carry and compensation data, extreme care must be taken to maintain control this data and ensure calculations are correct. Private equity and other AIFs are currently enhancing their use of technology to improve controls, efficiencies, and scalability. Outlined here are key areas of focus as firms improve controls.

1. Spreadsheet Management

Historically, spreadsheets have been the core method to manage carried interest allocations and other compensation arrangements. While many firms are moving towards using systems to manage carry and compensation data, certain spreadsheets will remain and should be stored in a highly secure location with version control protocols and back-up storage, in case files become corrupt or mistakes are made within the files.

Additionally, best practices includes using password protection, periodic formula review, links vs. hard-coding numbers wherever possible, colour coding for user provided values vs. calculated amounts, and locking static cells.

2. Managing Data Across Funds

Many firms face challenges where there is lack of consistency in spreadsheet use across funds. Unless funds are close to liquidation, alignment of spreadsheet format across funds improves aggregated reporting, transferability to other team members, and efficiencies when/if transitioning to a new system.

3. Managing Allocations that Change Over Time

Managing allocation changes over time is particularly important as employees elevate within the firm. Discretionary awards, joiners and leavers also increase the risk of error in calculating carry awards. Software applications, as opposed to spreadsheets, provide built in capabilities for tracking and tagging of the changes.

4. Interfaces Across Systems

Carry and compensation data may not change frequently, and the volume of transactional activity may not be high, thereby not warranting direct data interfaces.

There is, however, a risk of mismanagement of the data among systems that can be mitigated by automating data interfaces — such as personal information from human resource systems, compensation data from payroll systems, and fund and investment performance metrics from accounting systems.

5. System Implementations

Implementing carry management solutions can be challenging due to the specialised nature of participant agreements and exceptions. Each firm in the private capital industry has unique circumstances that determine how they allocate carry and other deferred compensation awards.

When implementing a carry management solution, it is important to focus on the highest priority items and use an agile approach to gain benefits in iterations. For example, while the ultimate vision may be for a self-service platform to be installed for all participants to access their carry awards via an online portal, there may be required steppingstones before achieving this goal—such as reporting for a specific fund or producing initial carry and compensation statements.

To produce the necessary reports, there will be significant setup and configuration required to set the foundation of more sophisticated system functionalities.

6. Ongoing System Management

Carry and compensation management teams are small by design to protect the confidentiality of the data. Using systems to manage carry and compensation requires a centralised and secure location for this data for long-term scalability.

Since the users of the system(s) may be limited, it is important to cross train and to ensure appropriate ‘How To’ documentation is in place, so activities can be transitioned between team members efficiently.

7. Data Security

It cannot be overstated that carry and compensation information is extremely sensitive and should be handled with high security.

When implementing a solution, the following are key areas of focus from a security perspective:

  • Use password protection and document sharing portals approved by the IT department when sharing files with third parties.
  • Use software platforms that ‘link’ to the existing security protocols (i.e., active directory) and multi-factor authentication protocols.
  • Mask and anonymize highly sensitive data in program development and test environments.
  • Use system security functionality for access privileges if a broad set of users will have access to the system (i.e., so participants cannot see their co-worker’s compensation details).
  • Use approval workflows for highly sensitive activities (award updates, wire instruction updates, distribution notice production, etc.).
  • Use systems that have a data encryption framework in place.
8. Participant Access (Existing and Former Employees)

To provide reporting closer to that used for ‘private wealth management,’ many firms are enhancing their capabilities to allow individuals to access data and documents via a portal.

Historical documents and data can be housed in a central location, as well as provide the ability for individuals to update their personal information (if there are no other systems used for this). Online signatory functionality can also be used to manage approvals of award letters and other compensation statements.

It is extremely important to ensure that relevant cyber security protocols are followed, no matter the functionality used. For example, portals should have time-out function and should leverage the firm’s active directory protocols as outlined in the data security section above, along with all other data security measures within the firm’s cyber security program.

Conclusion: Where the Industry is Headed

Private equity firms and other AIFs will continue to evolve along with the financial world, from both a business and technology perspective.

Compensation is a major focus of management teams that must hire, retain and reward its people most effectively. Some firms will continue to see increased success, and others will face major challenges due to COVID-19 and all that it involves.

Regardless of COVID-19 impacts, the human resource function must actively manage compensation changes — both positive and challenging, due to terminations, furloughs, write downs and potential claw backs for certain investments and funds.

We expect that the industry will continue to take action to improve controls related to the carry and compensation function, given the complexities and sensitivity of this data. Firms will continue the transition from spreadsheets to new technology solutions; to improve controls, increase efficiencies and institute better reporting. Firms will continue to build more automated reporting for employees and partners compensation, as well as comprehensive reporting for budgeting, forecasting and analysis of initiatives related to diversity and equality of pay.

We are excited to see the industry evolve as we continue collaborating with our clients in to the asset management industry by helping them improve their use of technology for carried interest and compensation plans as well as other business areas.

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