What's More Powerful Than Compound Interest? Carried Interest

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Estimated read time: 3 minutes 56 seconds

1. What's More Powerful Than Compound Interest? Carried Interest

2. Deep Dive on Why 15 Minute Grocery Delivery is a Terrible Business Model

Good morning and happy Monday - let's get smarter

What's More Powerful Than Compound Interest? Carried Interest

“My wealth has come from a combination of living in America, some lucky genes, and compound interest” - Warren Buffett

Almost everyone is familiar with compound interest

Every finance book will tell you that compound interest is the key to early retirement

Make money, put your money to work as early as possible, and let time and compound interest work it's magic

Here's compound interests power below:

If you have ever wondered about why private equity or venture capital jobs are so lucrative, or why they founders of these firms can become billionaires -> carried interest (or carry for short)

Carried interest in layman's terms - Making money investing off of investing other people's money successfully

Sounds pretty great, right? I invest your money, and if we make a ton of money off of your money, I get to keep some of the profit?

The Power of Carry - Example

You (Limited Partner): Invest $10m in Devin's investment fund

Investment Terms: Devin's investment fund's fee structure is 20% carried interest

5 years later: The fund sells our investments for $25m, a $15m profit!

Even though we only invested your $10m, my carried interest gives me a cut of the profits (20%)

Carried Interest $ = $15m fund profit x .20% = $3m for my fund

So we invested your $10m of your money, we made $15m of profit, and I get $3m and you get $12m

What makes it better?

Carried interest gets taxed at capital gains tax rates due to a tax loophole that private equity firms lobby hard to protect

That can be a difference of 20%+ saved

So they invest your $, make $ from it, and pay capital gains tax rates as opposed to ordinary rates

Should You Invest in PE or VC?

So should you consider becoming a limited partner (someone who invests in the fund but doesn't make any investment decisions) in a PE fund or VC fund?

For this to make sense, you need to look at the return you'd get or expect to get net of fees versus other opportunities to invest your $

If the S&P 500 ETF with 0 fees returns on average 12%, that would be your benchmark to compare the fund you might invest in against

If the fund has historically return greater than 12% NET OF FEES (not gross), then it might make sense

The big question is whether the can generate a high enough return to justify you paying carried interest

Deep Dive on Why 15 Minute Grocery Delivery is a Terrible Business

The #1 law of business: You are in business to make money - sounds dumb and obvious, but amazingly not always true

Businesses that lose money on every transaction have never really made much sense to me

For example, during COVID when the number of Uber rides was substantially lower than normal, Uber had its best quarter

A business model where the less volume/the less people use your service the more profitable? Doesn't sound like a business I want to invest in

On the flip-side, you have food and grocery delivery that allegedly:

• Is unprofitable on a smaller scale

• As you scale to more and more transactions, the economics get better and the business makes money

Let's look at the unit economics or the profit/loss generated by the business on a per transaction level

Fridge No More

UberEats

If these businesses at large scale CAN start to generate profit, and generate cashflows, then they have value

But the thought process by investors is they invest in the business early when they are unprofitable, and 2-5 years from now they will be a market leader and no longer lose $ on each transaction

The problem?

That's not happening

These businesses are scaling but not becoming profitable at scale

This is an industry I think you will see slowly die with the exception of a few of the market leaders like Doordash, or the whale's will start to swallow the smaller fish and acquire them when they are under distress

Instacart had planned to IPO this year, but cancelled their filing and wants to wait for more favorable market conditions

Instacart even slashed their own private valuation by almost 40% a few months back

The Instacart team is macroaware and understand the challenges of inflation and slowing GDP on their business

For this reason, I would bet on a company like Instacart as well to be a successful player in the public markets when they do eventually go public

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.