Carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds. Carried interest is due to general partners based on their role rather than an initial investment in the fund. As a performance fee, carried interest aligns the general partner's compensation with the fund's returns. Carried interest is often only paid if the fund achieves a minimum return known as the hurdle rate.Carried interest typically qualifies for treatment as a long-term capital gain taxed at a lower rate than ordinary income.
Key Takeaways
Carried interest is a share of profits from a private equity, venture capital, or hedge fund paid as incentive compensation to the fund's general partner.
Carried interest typically is only paid if a fund achieves a specified minimum return.
In most cases, carried interest is considered a return on investment and taxed as a capital gain rather than ordinary income, usually at a lower rate.
Because carried interest is typically distributed after a period of years, it defers taxes in the manner of an unrealized capital gain.
Carried interest serves as the primary source of compensation for the general partner, typically amounting to 20% of a fund's returns. The general partner passes its gains through to the fund's managers.
Many general partners also charge a 2% annual management fee. Unlike the management fee, carried interest is only earned if a fund achieves a pre-agreed minimum return.
Carried interest can also be forfeited if the fund underperforms.For example, if fund targeted a 10% annual return but only returned 7% for a period of time, investors known as limited partners may be entitled under the terms of their investment agreement to "claw back" a portion of the carry paid to the general partner to cover the shortfall when the fund closes. Although the clawback provision is not an industry standard, it has been used to argue that carried interest should not be taxed as ordinary income.
The carried interest portion of a general partner's compensation typically vests over a number of years.
Carried interest has long been a controversial political issue, criticized as a “loophole” that allows private-equity managers to secure a reduced tax rate.
Taxation of Carried Interest
Carried interest on investments held longer than three years is subject to a long-term capital gains tax with a top rate of 20%, compared with the 37% top rate on ordinary income.
Critics argue taxing carried interest as long-term capital gains allows some of the richest Americans to unfairly defer and lower taxes on the bulk of their income.
Defenders of the status quo contend the tax code's treatment of carried interest is comparable to its handling of "sweat equity" business investments.
The minimum holding period on an investment required to qualify associated carried interest for treatment as a long-term capital gain was increased from one year to three by the 2017 Tax Cuts and Jobs Act. The Internal Revenue Service (IRS) issued complex rules related to the provision in 2021.
Private-equity and venture-capital fund holding periods typically range from five to seven years, however. Some in Congress have proposed requiring the annual reporting of imputed carried interest for immediate taxation as ordinary income.
Carried interest, or “carry” for short, is the percentage of a private fund's investment profits that a fund manager receives as compensation. Used primarily by private equity funds, including venture capital funds, carried interest is one of the primary ways fund managers are paid.
Carried interest serves as the primary source of compensation for the general partner, typically amounting to 20% of a fund's returns. The general partner passes its gains through to the fund's managers.
Carried interest represents the performance fee for the GP in a private equity fund. Investors are usually guaranteed a return of their capital plus a minimum hurdle rate of return before the GP shares in profits. Carried interest aligns the interests of the LPs with those of the GP in a private equity fund.
the carried interest is only paid to the Managers after all investors in the Fund (including Managers on the coinvest) have received an amount equal to their equity invested plus the hurdle rate, and. the managers maintain their co-investment in the Fund for at least five years.
Catch-up payments kick in only after investors recoup their original investment plus a minimum return, known as the “preferred return” or “hurdle rate.” Only then do sponsors begin to participate in returns, typically starting with a catch-up phase that continues until the sponsor receives an amount based on the ...
Specifically, critics allege that it misclassifies how asset managers make their money. While they receive carried interest as compensation for their work in managing a fund, they're taxed as though they'd risked their own money in an investment.
Although operating partners sometimes find companies to invest in, what they receive in compensation reflects their primary responsibilities. Venture partners generally get a more significant piece of the carry on any deals they initiate. Operating partners usually get less.
The typical carried interest rate charged to LPs is 20%—although some GPs can command higher rates. This means that after the LPs are repaid their original investment amount, the GPs will receive 20% of the profits from the fund, while the remaining 80% of profits are paid to the LPs.
Carry is typically based on the percentage of the total pool for each fund, and it vests over several years (often 5 years, back-end-loaded, and sometimes up to 10). It's normally paid once the fund has returned invested capital and achieved its hurdle rate for the entire fund – otherwise, clawbacks might be required.
The value should represent the present value of the expected cash flows, or, in other words, the future carried interest distributions, which can generally be determined using option pricing and/or discounted cash flow methodologies.
Negative carry happens anytime the cost of holding or financing an investment is higher than your return. So, if you borrow money to invest in an asset, and the interest paid on the borrowed funds is higher than the income generated by your investment, you will have a negative carry.
The carried interest rules recharacterize long-term capital gains held less than three years to short term. The holding period requirement applies to both applicable partnership interests (API) and the assets owned by the API.
Carry is calculated as a percentage — typically between 20% and 30%* — of the return on investment after limited partners have been paid out 1X their investment. Carry is split (though not always equally) between partners.
For example, a GP might get a 10% carry allocation that vests over a five-year holding period. If the investment manager leaves before the five years, they would only be entitled to the amount that has vested over that time.
Profits from carried interest are considered a return on investment for federal tax purposes. That means rather than incurring ordinary federal income taxes of up to 37%, carried interest receives preferential capital gains tax treatment, similar to other investments like stocks or real estate.
The carried interest arrangement is specific to the private equity firm, but in general, members of the investment team should not expect to receive any proceeds until at the very least reaching the senior associate level, which is still uncommon.
A "carried interest" (also known as a "promoted interest" or a "promote" in the real estate industry) is a financial interest in the long-term capital gain of a development. The “carried interest” is given to a general partner (GP), usually the developer, by the limited partners (LPs), the investors in the partnership.
In a hedge fund environment, carried interest is usually referred to as a "performance fee" and because it invests in liquid investments, it is often able to pay carried interest annually if the fund has generated a profit. This has implications for both the amount and timing of the taxes on the interest.
Hobby: Web surfing, Skiing, role-playing games, Sketching, Polo, Sewing, Genealogy
Introduction: My name is Maia Crooks Jr, I am a homely, joyous, shiny, successful, hilarious, thoughtful, joyous person who loves writing and wants to share my knowledge and understanding with you.
We notice you're using an ad blocker
Without advertising income, we can't keep making this site awesome for you.
:max_bytes(150000):strip_icc()/carried-interest-4199811-1-26a323a334474b859256ff3cb37b99e5.jpg "Carried Interest Explained: Who It Benefits and How It Works (1)")
