Carried interest, often referred to as “carry,” represents the share of profits that the general partners (GPs) of private equity, venture capital, or hedge funds receive as compensation. This incentive is typically structured as a percentage of the profits generated by the fund and aims to align the interests of the GPs with those of the investors (limited partners, or LPs).
The standard formula for carried interest is:
Historical Context of Carried Interest
The concept of carried interest dates back to medieval times when ship captains received a share of the profits from the cargo they transported. Over the centuries, this practice evolved, becoming a key component of modern-day private equity and venture capital compensation structures.
Beneficiaries of Carried Interest
- General Partners (GPs): The primary beneficiaries, receiving an additional financial incentive alongside management fees.
- Limited Partners (LPs): Indirect beneficiaries, as carried interest aligns GPs’ incentives with performance, potentially leading to higher returns.
Legal and Tax Considerations
Carried interest has been the subject of significant debate, particularly concerning its taxation. In many jurisdictions, carried interest is taxed as capital gains rather than ordinary income, benefiting the recipients with lower tax rates. This preferential treatment has faced scrutiny and calls for reform.
Carried Interest in Practice
Private Equity Funds
In private equity, carried interest typically kicks in after achieving a minimum return or hurdle rate, ensuring that GPs are rewarded only after LPs have received a predetermined return on their investment.
Venture Capital Funds
Similar to private equity, venture capital funds use carried interest to incentivize GPs, though the structure and expectations may differ based on the unique risk and return profiles of venture investments.
Hedge Funds
Hedge funds may also employ carried interest, though it is commonly referred to as a “performance fee.” This fee is often coupled with a high-water mark, ensuring that GPs are compensated only for net new profits.
Examples of Carried Interest Allocation
Imagine a private equity fund generates $100 million in profits, with a 20% carry agreement. The GPs would receive $20 million as carried interest, while the remaining $80 million is distributed among the LPs.
FAQs About Carried Interest
Q: Why is carried interest controversial? A: The primary controversy revolves around its tax treatment as capital gains, leading to lower tax rates for recipients compared to ordinary income.
Q: How does carried interest align GP and LP interests? A: By linking compensation to fund performance, GPs are motivated to maximize returns for LPs, fostering a shared goal of achieving high profits.
Q: Can carried interest be negotiated? A: Yes, the percentage and terms of carried interest can vary and are often negotiated between GPs and LPs during the fund formation.
Related Terms
- Management Fee: A fee paid by the fund to GPs for managing the fund, typically calculated as a percentage of the assets under management (AUM).
- Hurdle Rate: The minimum rate of return that a fund must achieve before GPs can receive carried interest.
- High-Water Mark: A benchmark ensuring that GPs earn performance fees only on new profits, preventing double-dipping on the same gains.
Summary
Carried interest plays a crucial role in the financial incentives of private equity, venture capital, and hedge funds, aligning the interests of fund managers and investors. While benefiting GPs and potentially enhancing investor returns, its preferential tax treatment remains a contentious issue. Understanding its mechanics, historical context, and implications can provide valuable insights for both financial professionals and investors.
References
- Kaplan, S. N., & Schoar, A. (2005). Private Equity Performance: Returns, Persistence, and Capital Flows. The Journal of Finance, 60(4), 1673–1803.
- Metrick, A., & Yasuda, A. (2010). The Economics of Private Equity Funds. The Review of Financial Studies, 23(6), 2303–2341.
