What Is Carried Interest?

What Is Carried Interest?

Let me explain carried interest to you directly: it's the profit share that general partners in private equity, venture capital, and hedge funds earn. This setup ties their pay to how well the fund performs, motivating them to deliver strong returns.

Key Takeaways

You should know that carried interest is the profit portion general partners get, and it's frequently taxed at the lower capital gains rate. This compensation kicks in only when the fund beats a set return level. On top of that, many funds add a 2% annual management fee. The big debate comes from treating it as a capital gain, which can lower taxes for high-earning managers.

Understanding the Mechanics of Carried Interest

Carried interest is the main way general partners get compensated, usually taking 20% of the fund's returns, which they then distribute to the managers. You'll often see a 2% annual management fee charged as well, but unlike that fee, carried interest only pays out if the fund hits a predefined minimum return.

If the fund doesn't perform well, carried interest can be clawed back. For instance, if the target was 10% annual return but it only hit 7% over time, limited partners might reclaim some of the carry from the general partner to make up the difference when the fund wraps up, as per their agreement.

While not every fund has a clawback, it's been pointed to as a reason why carried interest shouldn't be taxed like ordinary income. Also, this carry typically vests over several years for the general partner.

Keep in mind, carried interest gets called a 'loophole' because it lets private equity managers pay lower taxes.

Tax Implications of Carried Interest

For investments held over three years, carried interest faces long-term capital gains tax at a max of 20%, versus 37% for ordinary income. Critics argue this lets the rich defer and cut their taxes unfairly, while supporters compare it to 'sweat equity' that's taxed similarly.

The 2017 Tax Cuts and Jobs Act bumped the holding period from one to three years, and in 2021, the IRS put out detailed rules on it. Funds in private equity and venture capital usually hold for five to seven years. Some lawmakers want to require annual reporting of carried interest to tax it as ordinary income right away.

What Does a 20% Carried Interest Mean?

A 20% carried interest is simply the performance fee paid to general partners from the limited partnership's profits. Once limited partners get their initial investment back, the general partners take 20% of the remaining profits.

Why Is Carried Interest Controversial?

The controversy stems from its taxation as capital gains, which is lower than ordinary income rates. This means partners earning through carry might pay less tax than regular employees, even while making more money, leading to perceived tax inequality.

What Does a Carried Interest Clawback Mean?

A clawback lets the firm recover excess profits paid to the general partner if it exceeds the agreed amount. Say the partner was set for 30% but got 35%; limited partners can then claw back that 5%.

Carried Interest: Key Insights and Final Thoughts

In summary, carried interest is a key pay source for general partners in these funds, linking their earnings to performance instead of upfront investment. It's often 20% of profits after hitting a return goal, taxed at capital gains rates, which fuels debates on fairness. Still, it stays central to the industry, rewarding effective management.