Carried interest

What Is Carried Interest?

Carried interest is a share of an investment fund's profits paid to the fund managers as a form of performance-based compensation. It is a key component of investment compensation within alternative asset classes such as private equity, venture capital, and hedge funds. This share typically represents a significant portion of the total profits generated by the investment funds, designed to align the interests of the fund's managers with those of its investors, or limited partners. Unlike fixed salaries or annual management fees, carried interest is contingent upon the fund achieving profitable returns, thereby acting as a powerful incentive for strong performance.

History and Origin

The concept of carried interest has historical roots tracing back to the 16th century. During this era, ship captains involved in maritime trade would receive a share, often around 20%, of the profits from the goods they successfully "carried" across oceans. This compensation model was a form of performance fees, rewarding the captains for the risks undertaken during long voyages.⁹ The modern application of carried interest evolved significantly, becoming a standard compensation structure in the alternative investment industry during the late 20th century, particularly with the growth of private equity and venture capital. Initially rooted in partnerships where expertise or "sweat equity" was contributed rather than capital, this profit-sharing arrangement became integral to how general partners are compensated for their investment acumen and deal-making abilities.⁸

Key Takeaways

• Carried interest is a share of investment profits paid to fund managers in alternative investment funds.
• It serves as a performance incentive, typically paid only after investors receive their initial capital and a preferred return.
• The standard carried interest split is often 20% to the general partner and 80% to limited partners, though this can vary.
• In the United States, carried interest may be taxed at favorable capital gains rates rather than higher ordinary income rates, subject to specific holding period requirements.
• This compensation structure aims to align the interests of fund managers and investors.

Formula and Calculation

Carried interest is calculated based on the net profits of a fund, often after certain investor thresholds have been met. A common structure involves a "waterfall" distribution model, ensuring limited partners recover their initial capital and any preferred return before the general partner receives carried interest.

The general formula can be conceptualized as:

Where:

• Net Profits are the total gains realized from the fund's investments after all expenses.
• Carried Interest Percentage is the agreed-upon share for the fund managers (e.g., 20%).
• Hurdle Amount represents the total capital returned to limited partners plus any predefined hurdle rate or preferred return. This ensures investors achieve a minimum return before managers participate in the profits.

For instance, if a fund has total profits of $100 million and a hurdle amount of $50 million (representing capital returned and preferred return), and the carried interest percentage is 20%:

This $10,000,000 would be the carried interest distributed to the fund's general partners.

Interpreting Carried Interest

Carried interest is a powerful incentive structure in the world of alternative investments, particularly within a partnership framework. Its interpretation is crucial for both fund managers and investors. For managers, a higher potential carried interest signifies greater reward for successful portfolio management and deal execution. It incentivizes them to maximize returns for the fund's limited partners. For investors, the presence of carried interest, especially when tied to a hurdle rate, indicates that the general partner's compensation is directly linked to the fund's profitability and their ability to generate returns above a certain threshold. This alignment of interests is often cited as a benefit, ensuring managers are motivated to achieve strong long-term performance rather than focusing on short-term gains or simply increasing assets under management.

Hypothetical Example

Consider "Alpha Growth Fund," a hypothetical private equity fund. The fund raises $200 million from limited partners and has a standard 80/20 profit-sharing agreement for carried interest, with a preferred return of 8%.

1. Investment Phase: Alpha Growth Fund invests the $200 million over five years in various companies.
2. Exit and Realization: After seven years, the fund begins to sell its portfolio companies. Through successful strategic improvements and market conditions, the fund generates total proceeds of $350 million from these exits.
3. Capital Return to LPs: The first $200 million is returned to the limited partners, representing their initial capital.
4. Preferred Return to LPs: The limited partners are then paid their 8% preferred return on the original $200 million over the seven-year period. Assuming simple interest for this example, that's $16 million per year, or $112 million over seven years.
5. Remaining Profits: After returning initial capital ($200 million) and the preferred return ($112 million), the total amount distributed to LPs is $312 million. The fund has $350 million in total proceeds, leaving a profit of $38 million ($350 million - $312 million).
6. Carried Interest Calculation: Now, the 80/20 split applies to this remaining $38 million in profit.
   • 20% goes to the general partner as carried interest: (0.20 \times $38,000,000 = $7,600,000).
   • 80% goes to the limited partners: (0.80 \times $38,000,000 = $30,400,000).

In this example, the fund managers of Alpha Growth Fund would receive $7.6 million in carried interest for their role in generating the profit.

Practical Applications

Carried interest is a fundamental aspect of compensation within alternative investment vehicles, playing a critical role in structuring incentives and distributing wealth in these specialized markets. It is most commonly found in:

• Private Equity Funds: General partners receive a share of the profits from successful buyouts and investments after returning capital to limited partners. This aligns the managers' interests with increasing the valuation of portfolio companies and ultimately their profitable liquidation.
• Venture Capital Funds: Similar to private equity, venture capital firms earn carried interest from the profitable exits (e.g., IPOs or acquisitions) of their portfolio startups. This incentivizes them to identify and nurture high-growth potential businesses.
• Hedge Funds: While often structured differently (e.g., "2 and 20" fee structure, where 2% is a management fee and 20% is carried interest on profits), hedge fund managers also earn carried interest based on investment performance.
• Real Estate Investment Funds: Managers of real estate funds often receive a promote (another term for carried interest) on property sales that exceed certain return hurdles for investors.

The taxation of carried interest is a frequent topic of debate. In the U.S., profits from carried interest on assets held for more than three years are typically taxed at long-term capital gains rates, which are generally lower than ordinary income tax rates.⁷,⁶ This preferential tax treatment has significant financial implications for fund managers.

Limitations and Criticisms

Despite its role in aligning incentives, carried interest faces notable limitations and criticisms, primarily concerning its tax treatment and perceived fairness. The most significant critique centers on the fact that carried interest, which is essentially compensation for services rendered by fund managers, is often taxed at the lower long-term capital gains rate, rather than the higher ordinary income tax rate that applies to most other forms of labor income.⁵

Critics argue that this distinction creates a "carried interest loophole," allowing wealthy investment professionals to pay a significantly lower effective tax rate than many middle-class workers.⁴ While proponents argue that this tax treatment encourages risk-taking and entrepreneurial activity by acknowledging the "sweat equity" and long-term investment horizon involved, opponents contend that it distorts the tax system and disproportionately benefits high-income earners.³

Legislation, such as Section 1061 of the Internal Revenue Code, has sought to address some of these concerns by requiring a three-year holding period for assets to qualify for long-term capital gains treatment on carried interest, an increase from the typical one-year holding period for other capital gains.² However, for many private equity and venture capital investments, the holding periods often naturally exceed three years, thereby limiting the practical impact of this reform for a significant portion of carried interest.¹

Carried Interest vs. Management Fees

Carried interest and management fees are both forms of compensation for fund managers within investment funds, but they differ fundamentally in their nature and purpose.

While management fees provide a stable revenue stream to cover the ongoing operational expenses of the firm, carried interest serves as the primary incentive for general partner to generate substantial returns for limited partners. The potential for significant carried interest payouts motivates managers to achieve exceptional investment outcomes.

FAQs

What types of investment funds typically involve carried interest?

Carried interest is a common compensation structure in private equity funds, venture capital funds, and hedge funds. These are generally alternative investment vehicles where managers actively identify and manage specific investments over a long-term horizon.

Why is carried interest often a controversial topic?

The controversy around carried interest primarily stems from its taxation. Critics argue that it allows fund managers to pay a lower capital gains tax rate on what is essentially compensation for their services, rather than the higher ordinary income tax rate.

Does carried interest always guarantee a payout for fund managers?

No, carried interest is performance-based and is not guaranteed. It is typically paid only if the investment funds generate profits above a certain threshold, often after the limited partners have received their initial capital back and sometimes a predefined hurdle rate or preferred return. If the fund performs poorly or fails to meet these conditions, the general partner may receive little to no carried interest.