carried interest

What is carried interest?

Carried interest is the portion of any profits that private equity and hedge fund general partners receive as compensation, whether or not they provided any initial funding. Since carried interest acts as a performance fee, it can incentivize the fund’s overall performance. However, carried interest is usually paid only when the fund’s returns reach a certain threshold.

What is carried interest?

key takeaways

  • Carried interest is a portion of private equity or fund profits as compensation to fund managers.
  • Carried interest is not automatic and is only issued when the fund’s performance is at or above a specified level.
  • If the fund doesn’t go as planned, this cuts the carried interest and thus cuts the fund manager’s compensation.
  • Since carried interest is considered investment return, it is taxed at the capital gains rate rather than the income rate.
  • Advocates of carried interest argue that it incentivizes the management of companies and funds to be profitable.

How carried interest works

Carried interest is the general partner’s main source of income and typically makes up about a quarter of the fund’s annual profits. While all funds tend to charge a small management fee, this is only to cover the cost of managing the fund, with the exception of the fund manager’s compensation. However, the general partner must ensure that all initial capital provided by the limited partner is returned along with some previously agreed rate of return.

Carried interest has long been a point of contention in the United States, and many politicians see it as a “loophole” that would allow private equity investments to avoid being taxed at reasonable rates.

How Businesses Use Carried Interest

General partners are compensated through an annual management fee, typically equal to 2% of the fund’s assets. The carried interest portion of general partner compensation vests over a number of years, after which it is received only when earned.

The private equity industry has long considered this a fair compensation arrangement because general partners invest significant time and resources in building the profitability of companies in their portfolios. General partners spend most of their time developing strategy, working to improve management performance and firm efficiency, and maximizing firm value in preparation for a sale or initial public offering (IPO).

special attention items

Carried interest is subject to capital gains tax. This rate is lower than income tax or self-employment tax, which is the rate that applies to management fees. Critics of carried interest, however, want it to be reclassified as ordinary income, taxed at ordinary income tax rates. Private equity advocates argue that higher taxes will reduce the incentive to take the risk necessary to invest in and manage companies for profit.

Carried Interest Example

The typical carried interest amount for private equity and hedge funds is 20%. Notable examples of private equity funds that charge carried interest include The Carlyle Group and Bain Capital. However, these funds have been charging higher carry rates of late, so-called “super arbitrage” of up to 30%.

Carried interest is not automatic; it is only created when the fund generates profits that exceed a specified level of return (often called the hurdle rate). If the minimum rate of return is not met, GPs don’t get the spread, although LPs get their proportional share. Arbitrage can also be “recovered” if the fund underperforms.

For example, if the LP is expecting a 10% annual return and the fund returns only 7% over a period of time, a portion of the spread paid to the GP can be returned to cover the shortfall. The clawback clause, along with other risks borne by the general partner, has led private equity industry advocates to argue that carried interest is not a salary — rather, it is a return on a risky investment that can only be paid based on performance.

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