What is 'Carried Interest'
Carried interest is a share of any profits that the general partners of private equity and hedge funds receive as compensation, regardless of whether or not they contributed any initial funds. This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund's performance.
BREAKING DOWN 'Carried Interest'Traditionally, the amount of carried interest comes out to around 20 to 25% of the fund's annual profit. While all funds tend to charge a small management fee, it is meant to only cover the costs of managing the fund with the exception of compensating the fund manager. Carried interest serves as the primary source of income for the general partner. However, the general partner must ensure that all the initial capital that the limited partners contribute is returned along with some previously agreed upon rate of return.
How Carried Interest Works
The general partner is compensated through an annual management fee, which typically amounts to 2% of the fund’s assets. The larger portion of compensation is generated through the general partner's share of the fund's profit, which is called carried interest. The carried interest portion, which typically amounts to 20% of the net profits, is vested over a number of years and received as earned after that point. The private equity industry has always maintained that this is a fair compensation arrangement because the general partner invests a tremendous amount of time and resources towards building the companies in their portfolio to profitability. Much of the general partner's time is spent in developing strategy, working to improve management performance and company efficiencies, and maximizing the value of a company in preparation for its sale or initial public offering (IPO).
Profit or Salary?
Carry is not automatic; it is only created when the fund generates profits that exceed a specified return level known as the hurdle rate. If the hurdle rate of return is not achieved, the general partner does not receive carry, although the limited partners continue to receive their proportionate share. Carry can also be clawed-back if the fund underperforms over time. For example, if the limited partners are expecting a 10% annual return, and the fund only returns 7% over a period of time, a portion of the carry paid to the general partner could be returned to cover the deficiency. The clawback provision, when added to the other risks the general partner undertakes, leads private equity industry advocates to their justification that carried interest is not a salary; instead, it is an at-risk return on investment that is only payable based on performance achievement.
Carried interest is classified under the tax code as capital gains, which are taxed at the more favorable capital gains tax rate. Critics of carried interest want it to be reclassified as ordinary income to be taxed at the ordinary income tax rate. Private equity advocates that the increased tax will subdue the incentive to take the kind of risk that is necessary to invest in and manage companies to profitability.