Carried interest is a controversial topic relating to the compensation of general partners in private equity, hedge fund and related investments. Here is an explanation and discussion of carried interest.

What Is Carried Interest?

Carried interest is generally the largest share of the general partner's profits from a private equity fund or a hedge fund. The general partner usually receives an annual management fee, often around 2% of assets. Carried interest is often referred to as the "carry."

The carried interest piece is generally a percentage of the profits generated by the fund. Carried interest is the portion of the fund's profits that the general partner receives as the major part of their compensation.

The general partner is usually a partnership of investment managers who contribute anywhere from 1% to 5% of the fund's initial capital. They receive their share of the ongoing management fee and certainly have a vested interest in the fund doing well from that standpoint alone. However, the "real money" stands to be made from the carried interest component of their compensation. 

How Does Carried Interest Work?

Carried interest is only created when the fund generates profits. Carried interest is generally tied to a specified rate of return known as a hurdle rate. If, for example, the fund's target return is 12% and it only earns 8%, the general partner might earn no carry or have their compensation from carried interest reduced or eliminated altogether depending upon the general partner's agreement with the fund.

A typical fund structure might pay the general partner an ongoing fee of 2% annually. The carried interest portion is where their big payoff lies, this might entail 20% of the fund's profits over a set time period like five years.

Carried interest usually vests over a period of years. Even if the fund's target return is met over the appropriate time period, a portion of the carried interest may be "clawed back" due to shortfalls in subsequent years. This would be part of the contractual arrangement between the general partners and the fund. Claw back provisions may include:

  • The minimum hurdle rate for the limited partners in the fund was not satisfied over a specified period of time.
  • Carried interest paid to the general partners previously exceeded the cumulative net gain of the fund due to subsequent losses incurred by the fund.

Then accounting treatment for carried interest and any potential claw backs is complex:

  • The fund should account for the unearned portion of the carried interest as of the reporting date even if it has not been paid out at that point.
  • The fund's financial statements should also reflect the claw back provisions of the general partner as a negative entry against the capital account.

At the time the carried interest is to be paid, it's important that the fund has an appropriate individual valuation of the fund's assets to support the payment. In most cases the underlying assets of the fund are not publicly traded, hence the need for an independent valuation.

Why Is Carried Interest Important?

Carried interest is an important issue for those investing in private equity funds, hedge funds and other funds with a similar structure. For the fund investors it's always important to understand their potential to profit from their investment in the fund, including how fund profits will be distributed. Carried interest can be a sizable piece of the fund's profits and investors should always be sure to understand how the carry structure works before investing.

The amount of carried interest paid by investors to the general partners of these funds is usually not an insignificant amount. This means there is less for the fund's investors. They need to weigh this potential cost against the upside potential they see in the fund, including what the general partner's expertise can potentially bring to the table. Will they potentially be better off financially by investing in the fund and paying the carried interest as opposed to investing their money someplace else?

Reasons to Consider Using Carried Interest

For better or worse, the carried interest compensation structure is the norm in the private equity and hedge fund world. These funds are all about generating outsize profits for investors. In order to attract top general partners as fund managers, they need to be compensated at high levels.

Experienced investors in the venture capital or private equity space might be tempted to forgo an investment in a fund that will pay out 20% of the fund's profits to a general partner in the form of carried interest. They may feel that their own experience in this space will allow them to select solid investment options and forgo paying out the carried interest portion of their invested capital.

Theses investors need to evaluate whether or not the expertise the general partners of the fund they are considering can add enough value to justify the carried interest that they could potentially earn.

How Carried Interest Is Taxed

Carried interest is considered to be capital gains and hence is taxed at preferential capital gains rates. Critics say this is unjust and that these payments should be taxed as ordinary income. This issue has been the subject of a number of political debates over tax policy in recent years.

The argument for taxing carried interest at capital gains rates is that general partners are akin to other entrepreneurs who start a business and get to treat portions of their return from that business as capital gains, not exclusively wages and salary.

Those on the other side of the argument liken the general partners to investment bankers who receive their compensation as wages, including the portion of their compensation that is tied to a bonus system. This compensation is taxed at ordinary income tax rates.

The Tax Cut and Jobs Act passed at the end of 2017 did change the rules on carried interest a bit. The new tax rules require that the fund hold the investments for three years versus the one year normally required to qualify for capital gains treatment. Assets sold prior to the three-year holding period would be taxed at a top rate of 40.8%. In reality this may not be a major factor for the funds as the average holding period for investments often exceeds three years.

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