Carried interest, the share of profits allocated to a fund’s general partner (GP), is a defining feature of private equity, private credit, and real estate funds. For fund accountants, accurately accruing carried interest is both a technical and practical challenge, requiring a blend of accounting rigor, system discipline, and clear communication with stakeholders.
What Is Carried Interest Accrual?
Carried interest accrual is the process of estimating and recording the GP’s share of future profits as they are earned, but before they are actually distributed. This accrual ensures that financial statements reflect the economic reality of the fund’s performance, even if cash hasn’t changed hands.
The Mechanics: Step-by-Step
Waterfall Modeling: Fund accountants start by modeling the fund’s distribution waterfall, which defines how profits flow to limited partners (LPs) and the GP. This includes preferred returns (hurdles), catch-up provisions, and the carried interest split.
Calculating Net Profits: Accountants determine net profits available for distribution, factoring in realized gains, losses, management fees, expenses, and any clawback provisions.
Applying the Waterfall: Using the modeled waterfall, accountants simulate distributions as if the fund were liquidated at the reporting date. This “hypothetical liquidation” approach is standard practice.
Accruing Carried Interest: The GP’s share of hypothetical profits is accrued as a liability (or equity allocation) on the fund’s books. This accrual is reversed or adjusted as actual distributions occur or as fund performance changes.
Testing for Clawback and Hurdle Compliance: Accountants must ensure that accruals do not overstate the GP’s entitlement, especially if the fund’s performance is volatile or if there are clawback provisions that could require the GP to return previously distributed carry.
Reporting and Disclosure: Carried interest accruals are disclosed in the fund’s financial statements, often with detailed notes explaining the methodology and assumptions.
Key Challenges
Complexity of Waterfalls: Each fund’s waterfall can be unique, with bespoke hurdles, catch-ups, and tiered carry rates.
Valuation Uncertainty: Unrealized investments require fair value estimates, which can change quarter to quarter.
Clawback Risk: Over-accrual can lead to future clawbacks, so accountants must be conservative and transparent.
Stakeholder Communication: LPs, auditors, and GPs all scrutinize carry accruals, making documentation and rationale critical.
Practical Example
Suppose a fund has a standard “20 over 8” waterfall (20% carry after an 8% preferred return). At quarter-end, the fund’s investments are valued, and the waterfall is run as if all assets were sold. If the hypothetical distribution would result in $10 million of carry to the GP, that amount is accrued, even though no cash has been paid out.
If, in a future period, asset values decline and the hypothetical carry drops to $7 million, the accrual is reduced accordingly. If the fund later realizes gains and distributes profits, the accrual is reversed as cash is paid.
Conclusion
Carried interest accruals are a core responsibility for fund accountants, requiring a disciplined approach to modeling waterfalls, estimating profits, and maintaining transparency with stakeholders. By applying consistent methodologies and staying vigilant about fund-specific nuances, accountants help ensure that financial statements accurately reflect the fund’s economic reality, supporting trust and clarity for both GPs and LPs.