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Carried interest is the percentage of a private equity or a hedge fund’s profits that its general partners receive as compensation.

Traditionally, a general partner’s carried interest is 20-to-25% of the fund’s annual profit, after investors receive their returns. The general partner does not contribute any money to the initial fund. Most funds have a management fee, but it’s usually small, say around 2%. The carried interest provides the general partner with incentive to improve the fund’s performance.

Carried interest works like this:

A private equity firm combines capital from investors or limited partners to invest over time. The firm’s general partners provide the investing expertise to help the fund grow.

The fund, which can be invested in stocks, bonds, real estate or another type of security, pays profits on its gains to the investors who provided the capital. Carried interest goes to the general partners who managed the fund.

Carried interest is taxed as a capital gain, which is lower than the ordinary income tax rate. General partners are essentially rewarded for assuming the risks and taking on the work that the fund requires.

Carried interest is intended to be the primary income for the general partner. However, the general partner must ensure that all the initial capital that the limited partners contributed is returned, along with some previously agreed-upon additional rate of return.

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