Each private equity firm has its own formula for distributing carry across the firm’s managing partners, senior managers, and staff. Carry distribution within the firm depends on title, years of work experience, and contribution to fund performance.

There are many differences in how Limited Partners and fund managers calculate net profits and carry.

Majority Rule: Under Majority Rule, net profit is calculated by adding all investments gains and income items, and subtracting every expense, including management fees paid to the General Partner. Carry is then a percentage of this net profit.

Pro-General Partner Rule: In this, net profit is calculated by adding only investment gains and subtracting only losses on portfolio investments. Fund expenses, such as management fees, are excluded from the profit calculation.

With the pro-General Partner Rule, items of realized gain and loss upon only the sale of portfolio securities are allocated 80% to all Partners (proportional to their respective capital commitments) and 20% to the General Partner. All other items of income, gain, loss and expense (including management fees) are allocated 100% to all partners in proportion to their respective capital commitments.

Carry Distribution

Pro-Limited Partner: First, all partners get back their contributed capital and hurdle, then 80% of the profits get distributed to all Partners proportional to their capital commitments, 20% gets distributed to the General Partner.

Pro-General Partner: First, 80% of the profit gets distributed to all partners in proportion to their contributed capital. Next, 20% of the profit goes to the General Partner until all profits have been distributed. Thereafter, partners are paid back their capital proportional to their respective commitments.

Middle of the Road: First, distribute 100% of the cost basis of the investment to all partners proportional to their capital commitments. Next, distribute profits (80% to all partners, 20% to the General Partner).

In general, only a Pro-Limited Partner approach prevents over-distribution to the General Partner, should investment losses follow investment gains. On the flip side, such an approach may cause the General Partner to manipulate distributions.

Here’s an example, provided by Wilson Sonsini Goodrich & Rosati, of an over-distribution under a Pro-General Partner approach:

Say a fund purchases Security A for $10 million and Security B for $10 million. The fund then sells Security A for $20 million, distributes $18 million to Limited Partners and gives $2 million to the General Partner. Security B then drops in value to $0 and the fund dissolves. In this case, the partners lost $2 million overall (invested $20 million but only received $18 million back), yet the General Partner received $2 million in carry even though net profits were $0.