Definition

Carried Interest

  • Updated on

What do you mean by Carried Interest?

Carried interest is also termed as Capital Gains Income. Carried interest entitles the general partners of a private equity fund or hedge funds to receive a share of the funds profit. Typically, private equity firms partner with investors creating a pool of capital to buy and strengthen companies over time. The investors contribute capital to the fund and the private equity partners provide capital and entrepreneurial expertise. When the private equity firm sells the company, its limited partners like - universal endowments, charitable funds and pension funds receive their initial investment at a guaranteed rate of return usually 8 percent plus 80 percent of profits while the remaining 20 percent goes to private equity firms. It is to be noted that capital interest is issued only if the return from the funds, meet a certain threshold.

Summary
  • Carried interests are also considered as capital gains income and are taxed at capital gains rate.
  • Carried interest gives the right to the general partner (GP) of a private investment fund to share the funds profits.
  • The GP receives an annual management fees of 2 percent of the funds’ assets, in addition to a carried interest of 20 percent of funds’ profits.

Frequently Asked Questions (FAQs)

How does carried interest work?

General partners use carried interest as a source of earning. This is because the GP of a private investment fund charge the management fee in addition with an entitlement over a quarter of the fund's yearly profit. However, it is also necessary that the GP pays back the limited partners’ initial investment at a guaranteed rate of return which is usually 8 percent along with 80 percent of profits.

© Olandah23 | Megapixl.com

Is carried interest taxable? What is its management fee?

Carried interest are taxed at capital gains tax rate. This tax rate for carried interest is lower than the ordinary income tax rate. 

Typically, the GP gets the compensation via a yearly management fees, which is around 2 percent of the funds’ assets. The GP received its share of carried interest which is 20 percent of the funds profit when the profit exceeds a certain threshold popularly known as the "hurdle rate."

Carried interest is taxable and this has been a matter of debate since years now as to if it should be taxed or not. It is also believed that the compensation which the private equity firms receive is justified because the general managers here perform a lot of tasks starting from management of funds to providing their capital and entrepreneurial expertise towards the profitability of the companies. They spent a lot of time in strategising, improving management performance of the companies along with their efficiency and enhancing a company’s value in the market. It is worth mentioning that GP is entitled to the carried interest irrespective of whether the private equity personally contributed anything in the buying of the company that led to this profit.

Do all the private equity funds charge the same carried interest or there are some exceptions?

Usually, the distribution of profits among the limited partners and the general partner (private equity and hedge funds) is 80:20. However, there have been precedents when some of these private equity funds have been charging a higher carried interest rate. An example of this can be Carlyle Group and Bain Capital, which charge as high as 30 percent for what is known as “super carry.” Besides, other private equity groups that are charging this “super carry” are: Vista Equity Partners, Eurazeo and Altor in Europe. 

Are private investment firms always entitled to receive carried interest?

Carried interest for a private equity fund is not automatic. This means that it is only earned by a fund manager when the profits from a fund exceed a certain threshold also called the hurdle rate. If the GP fails to achieve this specified rate, the private equity investment firm is not entitled to receive the carried interest. However, in such a condition the limited partners get their proportionate share.

 Example:

Suppose a XYZ private equity fund, generates $2 million funds from limited partners and general partners. In this fund, investors have contributed $1.6 million, whereas the GP contributed $0.4 million.

  • In this case, 80 percent of the funds came from the limited partners, while approx. 20 percent was contributed by GP. After receiving this amount, GP makes investments in the target companies with an aim to earn profits.
  • After three years, the GP sells all the investments and receives a total of $3.5 million. In this scenario, limited partners would get $1.6 million as a compensation for their initial investment.
  • The remaining $1.9 million will be distributed between limited partners and general partners in the ratio 80:20 ratio.

Image Source: © Photoshop1991 | Megapixl.com

Why is carried issue a contentious topic?

Carried interest has been a hot topic especially in US since mid-2000s. Those against the carried interests have been objecting the ability of the fund managers for treating most of their assets as capital gains. The critics believe that in this way, the fund managers have been benefitting from the tax loopholes for receiving to what is equivalent to a salary without having to pay ordinary income tax rate which is 37 percent. Sources like wages, salaries, self-employment income – fall in the ordinary income tax rate criteria. The issue has gained momentum primarily after the assets managed by private equity and hedge funds witnessed a remarkable growth thereby leading to an increase in compensation for fund managers. The private equity players have often cited the claw back provision to justify that carried interest should not be treated as salary as it is a risk return on investment which is completely based on performance achievement.

What do you mean by hedge funds?

 Image Source: © 8vfand | Megapixl.com

Hedge fund refers to a private investment partnership that uses polled funds with an aim to earn active returns for investors by way of selling and buying equities and making use of leverage and derivatives. The management fee charges by hedge funds are 2 percent.