Definition of Carried Interest (The Carry)
Carried interest is a share of profits that are due to the general partners of private equity companies, venture capitalists and hedge funds. It’s only paid out if the fund is able to achieve a predetermined return, which is called the hurdle rate.
Because of this, it’s a type of performance-based incentive that’s designed to ensure that partners are paid an amount that’s determined by how well their funds are doing.
How is Carried Interest Taxed?
Taxation for carried interest varies from region to region, but it’s usually taxed as a capital gain, rather than as ordinary income. This also means that it’s taxed at a lower rate.
How Does Carried Interest Work?
Carried interest usually functions as the main form of compensation for general partners, although some general partners charge a management fee instead of or as well as carried interest. Management fees are always chargeable, whereas carried interest is only valid when the fund achieves a minimum return that’s agreed upon at the start of the management agreement.
What is a Clawback Provision?
Clawback provisions aren’t necessarily industry standards, but they’re still occasionally seen in agreements. The idea is that if a fund underperforms, investors might have the right to “clawback” part of the carried interest to cover the shortfall.
Why is Carried Interest Controversial?
Carried interest has been criticized by all sides of the political spectrum because it can be seen as a tax loophole that allows general partners to pay lower taxes. However, as we’ve seen, defenders of carried interest point out that it’s different to regular income, especially if there’s a clawback provision in place. It’s also important to note that carried interest is still taxed, it’s just taxed at a lower rate.
What is the Role of General Partners?
General partners are also occasionally called fund managers, and it’s their responsibility to organize and manage the fund, to find investors and to establish relationships with the companies that are within the portfolio. General partners generally contribute a smaller amount of capital but are responsible for taking on all of the risk.
What is the Role of Limited Partners?
Limited partners are the main investors in a fund, but they’re not responsible for the management, which falls to the general partners. When general partners and limited partners team up, they create a limited partnership.
Why is Carried Interest So Important?
Carried interest is important because it makes sure that general partners have “skin in the game”. They have a reason to take on risks and to work hard to ensure that their fund makes money, and it also provides protection for limited partners. That’s because the general partners won’t receive carried interest until after the limited partners have been paid back for their initial investment, along with a predetermined amount of profit.
How Much Carried Interest is Usually Paid to General Partners?
The rate of carried interest that’s paid generally varies from fund to fund, but it’s usually around 20-25% of the profits. This makes it much more profitable to general partners than their management fee, which is usually closer to 2%. There’s a concept called the “two and twenty principle” which states that general partners should receive a 2% management fee and 20% carried interest.