What is carried interest?
Carried interest, often referred to as “carry,” is a share of the profits earned by general partners (GPs) in private equity and venture capital funds. It serves as an incentive for the GPs to generate strong returns for the limited partners (LPs) who invest in the fund.
Carried interest in Private Equity and Venture Capital
Carried interest is a common compensation structure used in private equity and venture capital to align the interests of the GPs and LPs. GPs receive carried interest based on the fund’s performance, particularly when the fund achieves returns that exceed certain predefined thresholds.
What’s a Carry Hurdle?
A carry hurdle, also known as a hurdle rate, is the minimum rate of return that the fund must achieve before GPs become eligible for carried interest. It ensures that GPs are rewarded only when the fund surpasses a specified level of performance.
How does carried interest work?
Carried interest is typically calculated as a percentage of the fund’s profits above the carry hurdle. The standard carry percentage is 20%, meaning GPs would receive 20% of the profits above the hurdle rate.
Carried Interest Example
For example, if a private equity fund has achieved a return of 30% and the carry hurdle is 10%, the GPs would receive carried interest on the 20% (30% – 10%) of profits generated above the hurdle.
Who’s involved in carried interest?
|What they do
|Earnings (Carried Interest)
|General Partners (GPs)
|Manage the fund, make investment decisions, and oversee the portfolio companies.
|Carried interest, typically 20% of profits above the carry hurdle.
|Limited Partners (LPs)
|Invest capital in the fund and entrust GPs to generate returns.
|No carried interest. Earn returns on their investments.
The role of the general partner
The general partner is responsible for managing the private equity or venture capital fund. They make investment decisions, conduct due diligence on potential investments, and work closely with portfolio companies to enhance their value and drive growth.
General partner compensation
General partners are compensated through two main components:
- Management fee: An annual fee, typically 2% of committed capital, to cover the fund’s operating expenses.
- Carried interest: A share of the fund’s profits earned above the carry hurdle.
How do you calculate carried interest?
Carried interest is calculated based on the fund’s profits above the carry hurdle. The formula is typically:
Carried Interest = (Fund’s Profits – Carry Hurdle) * Carry Percentage
How is carried interest taxed?
Carried interest is treated as capital gains for tax purposes, which is subject to lower tax rates than ordinary income. This treatment has been a subject of controversy and is often referred to as the “carried interest loophole.”
Taxation of Carried Interest
The taxation of carried interest varies by country and is subject to specific tax regulations. In some jurisdictions, carried interest may be taxed at capital gains rates, while in others, it could be considered ordinary income.
How big is the carried interest loophole?
The carried interest loophole has been a contentious issue, with critics arguing that it allows wealthy fund managers to benefit from favorable tax treatment. The size of the loophole depends on the scale of private equity and venture capital activities in a particular country.
What are the key restrictions?
Various countries have implemented restrictions and regulations to address the carried interest loophole and its potential abuse. These restrictions aim to ensure that carried interest is taxed appropriately based on the nature of the income.
Why is carried interest controversial?
The controversy surrounding carried interest mainly stems from the tax treatment, which allows fund managers to pay a lower tax rate on their earnings compared to ordinary income tax rates.
What is the history of carried interest?
Carried interest has a long history in private equity and venture capital, dating back to the early days of these investment vehicles. The practice of awarding carried interest to fund managers has evolved over time and become a standard compensation structure in the industry.
The European-style waterfall is a distribution model that prioritizes returning capital to LPs before distributing carried interest to GPs. It focuses on achieving capital preservation and providing LPs with earlier access to returns.
The American-style waterfall distributes carried interest to GPs throughout the fund’s life cycle, even before returning capital to LPs. This approach offers GPs greater access to profits as the fund’s investments perform well.