When I set up a new venture fund at Sapphire, I am often asked about how the performance fee structure works and what the typical level of the performance fee is.
Understanding how performance fees work in a GP/LP fund is essential for both fund managers and investors in the UK venture capital market. Performance fees, often called “carried interest”, remain a central feature of the limited partnership model, aligning the interests of general partners ("GPs") and limited partners ("LPs") while ensuring transparency and compliance with the Financial Conduct Authority ("FCA"). This guide explains how performance fees are structured, calculated, and managed in venture funds, as well as what investors should look for when evaluating fund terms.
Below is a video summary of this article
What Is a GP/LP Structure in UK Venture Capital?
Most larger UK venture funds use a General Partner/Limited Partner ("GP/LP") structure (as opposed to smaller funds, which are often structured as SEIS or EIS alternative investment funds). The GP manages the fund’s investments and day-to-day operations, while LPs provide the capital and receive a share of the fund’s profits. This structure allows GPs to make investment decisions and LPs to participate passively, with their roles and rights defined in the Limited Partnership Agreement ("LPA").
How Do Performance Fees (Carried Interest) Work in Venture Funds?
Performance fees, also known as carried interest, are a share of the fund’s profits paid to the GP as an incentive for strong performance. In venture funds:
- The standard performance fee is typically 20% of profits, though the percentage can vary.
- Carried interest is only paid after LPs have received their initial investment back, and sometimes after a “hurdle rate” (minimum return threshold) is met.
- Fee structures and calculation methods are detailed in the LPA and the Information Memorandum ("IM").
- In some funds, “high-water marks” or other investor protections may be used to ensure fees are only paid on new net gains.
At Sapphire, the majority of our GP/LP funds have a performance fee of 20% of the profits, which is typically taken once the initial investment is repaid. Less common is that some funds take the performance fee on a deal-by-deal basis before the initial investment has been repaid.
Comparative Analysis of Fee Structures
| Model |
Management Fee |
Carried Interest |
Hurdle Rate |
When is Carry Paid? |
| Standard (2/20) |
2% |
20% |
0-8% |
After return of capital (+hurdle) |
| Tiered Carry |
2% |
20%-30% |
8%+ |
Higher carry if IRR exceeds targets |
| Deferred Carry |
1.5% |
20% (escrowed) |
8% |
Carry released after final closeout |
Technical Deep Dive: Performance Fee Calculation Methods
Example 1: Standard European-Style Waterfall with Hurdle Rate
Fund Terms:
Fund size: £50 million
Hurdle rate: 8% per annum (compounded)
Carried interest: 20%
GP commitment: 1% (£500,000)
All investments were exited after five years, yielding total proceeds of £80 million.
| Step |
Amount Paid |
Recipient |
| Return of Capital |
£50.00m |
LPs |
| Hurdle (8% compounded) |
£23.45m |
LPs |
| Residual Profits |
£6.55m |
Split |
| - Carried Interest |
£1.31m |
GP |
| - Remainder |
£5.24m |
LPs |
Example 2: Deal-by-Deal (American-Style) Waterfall with Clawback Provision
Fund Terms:
Fund size: £30 million
Carried interest: 20%
No hurdle rate
Three investments:
- Investment A: £10m → exits for £20m (profit)
- Investment B: £10m → exits for £8m (loss)
- Investment C: £10m → exits for £12m (profit)
| Investment |
Paid to GP |
Paid to LP |
| Investment A: £10m profit |
20% Carry to GP: £2m |
80% to LPs: £8m |
| Investment B: £2m loss (no carry) |
20% Carry to GP: £0 |
80% to LPs: £0 |
| Investment C: £2m profit |
20% Carry to GP: £0.4m |
80% to LPs: £1.6m |
|
Clawback Calculation: Total Profits: £10m Carry Entitlement (20%): £2m
Carry that was Paid to GP: £2.4m
Clawback owed by GP to LP: £0.4m
|
Example 3: Catch-Up Provision
Fund Terms:
Fund size: £40 million
Hurdle rate: 6%
Carried interest: 20% with 100% catch-up
Fund returns: £55 million after four years (profit of £15m)
| Return of Capital |
Paid to GP |
Paid to LP |
| On the first £40m to LPs |
£0 |
£40m |
| On the LP hurdle rate of 6% per annum |
£0 |
£9.6m (£40mx4yrsx6%) |
| Catch up for the GPs at 20% of profit of £15m |
£3m (£15mx20%) |
£0 |
| Remaining amount to LPs |
£0 |
£2.4m |
| TOTAL (totals £55m) |
£3m |
£52m |
Example 4: Tiered Carried Interest
Fund Terms:
Fund size: £100 million
Carried interest: 20% up to 2x return, 30% above 2x return
No hurdle rate
Fund returns: £250 million
| Return of Capital |
Paid to GP |
Paid to LP |
| On the first £100m to LPs |
£0 |
£100m |
| On the 20% up to 2x return to GPs |
£20m |
£0 |
| On the 30% above 2x return to GPs |
£15m |
£0 |
| Remaining amount to LPs |
£0 |
£115m |
| TOTAL (totals £250m) |
£35m |
£215m |
Example 5: High-Water Mark
Scenario:
Fund grows from £50m to £60m (Year 1). (High water mark is set at £60m)
Drops to £55m (Year 2)
Then rises to £65m (Year 3). (High water mark is set at £65m, £5m above prior mark of £60m)
Carried interest: 20%
Fund returns: £65m
| Return of Capital |
Paid to GP |
Paid to LP |
| Year 1 (NAV increase of £10m) |
£2m (£10x20%) |
£0 |
| Year 2 (NAV reduction of £5m) |
£0m |
£0 |
| Year 3 (NAV increase to £65m) |
£1m (£5mx20%) |
£0 |
| Remaining amount to LPs |
£0 |
£62m |
| TOTAL (totals £65m) |
£3m |
£62m |
Sensitivity Analysis and Scenario Modelling
How Hurdle Rate Affects Carry Example
| Scenario |
Hurdle Rate |
Total Fund Profit |
Carry Paid to GP |
Net to LPs |
| Base Case |
0% |
£30m |
£6m (20%) |
£24m |
| With Hurdle |
8% |
£30m |
£4m (20% of post-hurdle) |
£26m |
| Lower Return Case |
8% |
£10m |
£0 (no carry, hurdle not met) |
£10m |
Insight: Higher hurdle rates reduce the likelihood and amount of carry paid to GPs, especially in lower-return scenarios.
LP Negotiation Strategies and Common Requests
Outlined below are several approaches commonly employed by limited partners at Sapphire to strengthen their negotiating position.
- Require lower management fees for significant commitments or early investors.
- Enhanced clawback provisions or escrowed carry to protect against overpayment.
- Fee caps or step-downs after the investment period ends.
- Transparency on all side letters granted to other LPs.
GPs can respond by: Offering tiered fees, side letters for strategic investors, or increased reporting transparency.
Trends and Innovations in Fee Structures
Outlined below are several key trends shaping the current GP/LP fund landscape, which should be carefully considered when setting up a fund.
- Super Carry: GPs may earn 30%+ carried interest if IRR exceeds a high threshold (e.g., 25%).
- Deferred/Escrowed Carry: Carry is held in escrow and released only after fund wind-down to protect LPs.
- Fee Compression: Downward pressure on management fees as LPs demand better alignment.
- ESG-linked Carry: Carry increases/decreases based on meeting environmental, social, or governance targets.
- Digital Fund Admin: Increasing use of digital platforms for real-time reporting and compliance (at Sapphire, we utilise the platform provided by Further).
Taxation of Performance Fees in the UK
Carried interest is generally taxed as a capital gain in the UK, subject to specific HMRC rules (including the “disguised investment management fee” and “income-based carried interest” regimes).
- The standard capital gains tax rate applies if the GP meets the “substantial risk of capital” test and other conditions.
- Management fees, by contrast, are taxed as ordinary income.
- GPs and LPs should seek specialist tax advice to ensure compliance and optimal structuring.
Regulatory and Market Outlook
At Sapphire, we proactively manage a diverse portfolio of GP/LP funds, remaining closely attuned to evolving regulatory developments and market dynamics. Below, we share our current insights and observations on prevailing trends in the sector.
- FCA is reviewing transparency and disclosure requirements for alternative investment funds.
- HMRC continues to scrutinise carried interest and management fee arrangements.
- Global LPs are increasingly demanding harmonised terms and digital access to reporting.
- Brexit has led some funds to consider parallel structures in other European jurisdictions for cross-border investors.
Regulatory and Accounting Standards
Compliance with all relevant regulatory and accounting standards is a fundamental requirement for any GP/LP fund, including the following:
- UK venture funds must comply with the FCA's rules for Alternative Investment Fund Managers (AIFMs), including disclosure and reporting requirements.
- Fees should be calculated in accordance with UK GAAP or IFRS.
- The LPA, IM, and audited financial statements must clearly disclose all performance fee arrangements.
- Third-party fund administrators are commonly used to ensure accuracy and transparency in fee calculations.
Common Pitfalls and Disputes
It is crucial to be aware of the potential pitfalls and sources of dispute inherent in GP/LP fund structures before establishing a fund. Some of the most common include the following:
- Valuation of Illiquid Assets: Disagreements often arise over the value of portfolio companies, particularly when calculating carry before a final exit.
- Over/Under accrual of Carry: Inaccurate NAV or profit calculations can lead to disputes at fund close.
- Misinterpretation of LPA Terms: Ambiguity in waterfall or clawback language can cause costly legal disputes.
- Best Practice: Use precise, plain English drafting, conduct regular third-party audits, and maintain open LP-GP communication.
Checklist for LPs and GPs
Drawing on our extensive experience establishing GP/LP fund structures, we have identified the four most critical issues that both limited partners (LPs) and general partners (GPs) should address during fund formation.
For LPs:
- Review all fee terms and waterfall mechanics in the LPA.
- Confirm the existence and terms of hurdle rates, clawbacks, and high-water marks.
- Request sample carry calculations and audit procedures.
- Ask about side letters and MFN clauses.
For GPs:
- Ensure fee calculations are transparent and independently verified.
- Draft clear, unambiguous LPA language for all fee provisions.
- Prepare for FCA and HMRC scrutiny with proper documentation.
- Communicate proactively with LPs about any fee-related changes.
Best Practices for Managing Performance Fees in Venture Funds
Below are our recommendations for best practice in the management of GP/LP funds.
- Maintain clear documentation of fee terms in the LPA and the Information Memorandum.
- Use independent or shadow accounting to verify NAV and fee calculations.
- Adopt digital platforms for real-time investor reporting and compliance (we work with Further).
- Regularly review fee structures to ensure alignment with investor expectations and regulatory standards.
- Engage external legal and tax advisors for LPA drafting and compliance reviews.
Comparison with Other Jurisdictions
Fee structures, tax, and disclosure rules differ across markets, shaping fund strategy for managers and LPs. The following outlines the key distinctions between the UK, the US, and the EU.
- UK vs US: US funds often use deal-by-deal waterfalls, whereas UK/EU funds prefer whole-fund (European) waterfalls.
- Tax: Carried interest in the US is subject to a three-year holding period for favourable tax treatment; UK rules focus on “substantial risk of capital.”
- Disclosure: EU AIFMD imposes stricter disclosure and reporting requirements than the UK post-Brexit.
Frequently Asked Questions: Performance Fees in GP/LP Venture Funds
When assisting with the establishment of a GP/LP fund, we are frequently asked the following questions:
-
What is the typical performance fee in a UK venture fund?
Most venture funds charge a 20% performance fee (carried interest), but terms can vary.
-
Are hurdle rates common in UK venture funds?
Hurdle rates are less common in venture capital than in private equity, reflecting the higher risk and less predictable returns of VC investments.
-
How are performance fees calculated and paid?
Performance fees are calculated as a percentage of profits, typically after returning LPs’ capital and any preferred returns. The exact method is set out in the fund’s LPA.
-
What protections do LPs have regarding performance fees?
LPs benefit from provisions such as high-water marks, hurdle rates, and clawbacks, which help ensure that performance fees are paid fairly and only on actual profits.
- How is carried interest taxed for UK GPs?
Carried interest is usually taxed as a capital gain if HMRC conditions are met; otherwise, it may be taxed as income.
-
How does the UK regulatory environment affect performance fees?
UK fund managers are required to comply with FCA rules, AML/KYC requirements, and transparent fee disclosure standards.
Glossary of Key Terms
- Carried Interest (Carry): The share of profits paid to the GP as a performance fee.
- Hurdle Rate: The minimum return LPs must receive before carry is paid.
- Waterfall: The order in which fund profits are distributed between LPs and GPs.
- Clawback: Provision requiring the GP to return excess carry if the fund underperforms.
- High-Water Mark: Ensures carry is only paid on new net profits.
- Side Letter: A separate agreement granting special terms to specific LPs.
- NAV (Net Asset Value): The total value of fund assets minus liabilities.
- Catch-Up: A feature allowing the GP to “catch up” to their agreed share of profits after the hurdle is met.
Additional Resources and Tools
Conclusion
Performance fees in a GP/LP fund are a key incentive for general partners and a crucial consideration for limited partners in the UK venture capital sector. By understanding how these fees are structured, calculated, negotiated, and regulated, fund managers and investors can ensure fair alignment of interests and long-term fund success.
Next Steps:
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