Investing in alternative assets like private equity, venture capital, private credit, secondaries, and cross over funds used to be a playground for institutional giants such as pension funds, endowments, sovereign wealth funds, etc. But times are changing. With SEBI lowering the minimum investment for an AIF (Alternative Investment Fund) to ₹1 crore, more high-net-worth individuals and savvy retail investors are stepping into the arena.
Before you rush in, though, there’s one question worth asking: How do fund managers actually get paid? Because understanding that is key to understanding how your money works in these funds.
Two words: 1Management Fees and Carry. They sound simple, but they’re the building blocks of fund manager compensation and they come with nuances that can shape your returns.
1. Management Fees: The Fund’s Fuel
Think of management fees as the fund’s salary- fixed, predictable, and paid whether or not the fund knocks it out of the park. These fees usually hover between 1.5% to 2.5% of the fund’s committed capital or assets under management (AUM).
What do these fees cover?
- Salaries for the investment team and operations
- Endless research, deal sourcing, and due diligence
- Office rent, legal costs, compliance, etc
Management fees keep the fund running smoothly, but they’re not tied to the overall performance of the fund manager. Whether the fund wins big or falls flat, these fees are still paid.
That’s why carry exists: to reward real performance.
2. Carried Interest (Carry): The Real Prize
Carried interest or simply, carry — is the fun part. It’s the slice of profits fund managers earn after investors get their capital back (and sometimes, after hitting a minimum return).
Typically, carry is set at 20% of the fund’s profits, but for elite funds with a track record to outperform other Tier 1 funds (2Sequoia Capital), it can go up to as high as 30%. For newer funds trying to build trust, it might drop to 15%.
Carry exists for a reason:
- It keeps fund managers hungry to deliver outsized returns
- It aligns the manager’s success with their LPs (investors)
- It rewards the fund’s skill in picking winners and building portfolios
The Hurdle Rate: No Free Lunch
Here’s where it gets interesting. Most funds set a hurdle rate — a minimum return (often around 8% annually) that LPs must receive before the GP (fund manager) gets to taste any carry.
If the fund doesn’t clear that bar, there’s no carry
Why?
- It protects investors from paying for mediocre performance
- It ensures fund managers don’t profit from average returns
Waterfall Structures: Who Gets Paid First
Once profits come rolling in, how they’re distributed depends on the waterfall structure. There are two main ways fund managers decide who gets what, and when:
1. The American Waterfall (Deal-by-Deal)
In this setup, GPs start earning carry as soon as individual deals are exited. So even if the fund does great early on and flops later, managers could still walk away with carry. It’s great for GPs but riskier for LPs.
2. The European Waterfall (Whole-Fund Model)
This is the more LP-friendly structure. GPs only earn carry after the entire fund has returned all invested capital plus the hurdle rate. No shortcuts. It ensures investors are taken care of before fund managers start celebrating.
“Reputational Capital”- The Secret Sauce
At the end of the day, it all comes down to trust. The more established and reputable the fund, the greater their track record, the better terms they can command.
That means higher fees and carry percentages and GP-advantageous structures.
On the flip side, if you’re a first-time fund manager, you may need to sweeten the deal for LPs: lower management fee and carry, and investor-friendly terms until you’ve proven your mettle.
Bottom Line: Why Should You Care?
If you’re an investor dipping your toes into alternative assets or an aspiring fund manager looking to raise your first fund, understanding these mechanics is crucial.
A well-structured fee and carry model ensures that everyone’s rowing in the same direction.
Fund managers make money when they make money for you.
So before committing capital, look beyond the pitch deck and glossy returns. Ask about:
· Management fee
· Carry
· Hurdle Rate
· Waterfall Structure
Because in this game, how the fund manager gets paid can tell you a lot about how your investment might perform.
1. 1 Lerner, J., Hardymon, F., & Leamon, A. (2011). Note on the Private Equity Fundraising Process (HBS No. 9- 201-042, Rev. April 29, 2011). Boston: Harvard Business School Publishing.
2. https://www.axios.com/2021/10/26/sequoia-capital-fund-venture-capital-model?
