Carried Interest

Carried interest, also known as “carry,” is a share of the profits of an investment that is paid to the manager of a private equity firm or hedge fund.

The manager typically receives a percentage of the profits of the fund as a fee for managing the investment, regardless of whether the fund performs well or poorly.

The percentage of profits that the manager receives as carried interest is typically much higher than the fee that they would receive for managing the fund.

The practice of paying carried interest has been controversial, as some have argued that it allows fund managers to benefit disproportionately from the success of the fund, while others have defended it as a way to align the interests of the manager with those of the investors.

Key Takeaways – Carried Interest

• Carried interest is a share of profits paid to certain investment professionals, such as private equity fund managers or hedge fund managers.
• It is a form of compensation that is intended to incentivize these professionals to take on the risk and reward of making investments on behalf of the fund.
• Carried interest is typically paid when the investments made by the fund generate profits, either through the sale of the investments or an increase in their value.
• The amount of carried interest paid to investment professionals is typically a percentage of the profits earned by the fund.
• The tax treatment of carried interest can be complex and may vary depending on the specific circumstances and jurisdiction. In some cases, carried interest may be taxed at a lower rate than ordinary income (i.e., the capital gains rate).

What Is the Carried Interest Loophole?

The carried interest loophole refers to the fact that carried interest is often taxed at a lower rate than ordinary income.

In the United States, carried interest is typically taxed at the capital gains tax rate, which is lower than the tax rate applied to ordinary income.

This has led to criticism that the tax treatment of carried interest allows fund managers to pay a lower tax rate on their income than other individuals who are earning similar amounts of money.

Some have argued that the carried interest loophole should be closed, either by taxing carried interest at the same rate as ordinary income or by eliminating the preferential tax treatment of carried interest altogether.

Others have defended the tax treatment of carried interest as appropriate given the risks and uncertainties associated with managing an investment fund.

How Does Carried Interest Work?

Here’s how it works: the investment manager raises capital from investors and uses that capital to make investments in various assets, such as companies (e.g., stocks, bonds, corporate credit) or real estate.

If the investments are successful and generate profits, a portion of those profits, known as the carried interest, is given to the investment manager as compensation for their work.

The carried interest is typically a percentage of the profits, and it is typically higher than the fee that the investment manager charges for managing the fund.

This can create an incentive for the investment manager to take on greater risk, since they stand to profit more if the investments are successful.

It’s important to note that carried interest is considered a form of compensation, rather than a return on investment.

As such, it is typically taxed at a lower rate than the profits earned by the investors in the fund.

This has led to controversy and debate, with some arguing that the lower tax rate on carried interest is unfair and should be changed.

Carried Interest vs. Performance Fee

Carried interest and performance fee are both terms that refer to a share of the profits of an investment that is given to the investment manager as compensation.

However, they differ in how they are calculated and when they are paid.

Carried interest is a percentage of the profits of the investment, and it is typically paid after the investment has been sold and the profits have been realized.

The percentage of the profits that is paid as carried interest is typically agreed upon in advance and is higher than the fee that the investment manager charges for managing the fund.

Performance fee, on the other hand, is a percentage of the increase in the value of the investment over a certain period of time.

It’s usually paid out based on quarterly, semiannual, or annual performance, and is typically only paid if the value of the investment has increased.

The percentage of the increase in value that is paid as a performance fee is also typically agreed upon in advance.

Both carried interest and performance fees are commonly used in the context of private equity and hedge fund management, where the investment manager is responsible for making investment decisions on behalf of the fund.

Private Equity at Work: What is Carried Interest?

How Does Carried Interest Relate to the Hedge Fund Fee Structure?

In the context of hedge fund management, carried interest is typically a part of the overall fee structure that is used to compensate the investment manager.

The hedge fund fee structure typically consists of two main components:

• a management fee and
• a performance fee

The management fee is a percentage of the assets under management (AUM) that is charged by the investment manager for the day-to-day management of the fund.

It’s normally intended to cover the overhead expenses associated with running the fund, such as staff salaries, data, research, and rent.

The performance fee, also known as carried interest, is a percentage of the profits generated by the fund that is paid to the investment manager as compensation.

It is typically paid after the investments in the fund have been sold and the profits have been realized.

The percentage of the profits that is paid as a performance fee is typically higher than the management fee and is intended to incentivize the investment manager to generate strong returns for the fund.

FAQs – Carried Interest

Why is carried interest so controversial?

Carried interest has been the subject of much controversy because it is typically taxed at a lower rate than the profits earned by the investors in the fund.

Under US tax law, carried interest is treated as capital gain, which is taxed at a lower rate than ordinary income.

This has led to criticism from some quarters, who argue that the lower tax rate on carried interest is unfair and should be changed.

Critics argue that carried interest is really a form of compensation, rather than a return on investment, and should be taxed at the same rate as ordinary income.

Additionally, some have argued that the lower tax rate on carried interest provides an unfair advantage to investment managers and encourages them to take on excessive risk in pursuit of higher profits.

There have been numerous proposals to change the tax treatment of carried interest, but the controversy surrounding carried interest remains a topic of ongoing debate.

How is carried interest calculated?

Carry, or carried interest, is the share of profits that a manager of a private equity or hedge fund receives as compensation.

It is typically a percentage of the fund’s profits, and it is calculated by taking the profits that the fund has earned and dividing it by the amount of capital that the fund has invested.

This result is multiplied by the carry percentage to determine the manager’s share of the profits.

For example, if a private equity fund has invested $100 million in a company and the firm earns $50 million in profits (i.e., portfolio value of $150 million).

If the carry percentage is 20%, the manager would be entitled to 20% of the $50 million profit, or $10 million.

In private equity, carry is typically paid to the fund manager after the fund has been liquidated and all of the investments have been sold, and it is usually taxed at a lower rate than ordinary income.

For hedge funds in liquid markets, they may be able to achieve their performance fee based on public markings of the asset values without having to liquidate the positions.

Who benefits from carried interest?

Carry/carried interest is typically received by the managers of private equity and hedge funds as part of their compensation.

These managers are responsible for investing the fund’s capital and managing its portfolio of investments, and carry is intended to incentivize them to maximize the fund’s profits.

In addition to the fund managers, the investors in the fund may also benefit from carried interest if the fund is successful and generates profits.

Carry is typically paid out of the profits that the fund generates, so if the fund is successful, the investors may receive a larger return on their investment.

However, as mentioned, it is important to note that carry is a highly controversial form of compensation, and it has been the subject of plenty of debate and criticism.

Some argue that the lower tax rate applied to carry unfairly benefits fund managers and that it allows them to pay lower taxes on their income than those who earn their income through other means.

Others argue that carry is necessary to attract and retain talented fund managers and that it aligns the interests of the managers with those of the fund’s investors.

Why is it called carried interest?

The term “carried interest” refers to the fact that these investment professionals are carrying, or taking on, a share of the risk and reward of the investments made by the fund.

In return for taking on this risk, they are entitled to a percentage of the profits earned by the fund, which is paid to them as carried interest.

This is in addition to any other fees or compensation they may receive for managing the fund.

When is carried interest paid?

Carried interest is typically paid to investment professionals when the investments made by the fund generate profits.

This can occur when the fund sells its investments for a profit, or if the value of the investments increases while they are being held by the fund.

The exact timing of when carried interest is paid will depend on the terms of the fund and the investment professionals’ compensation agreements.

In some cases, carried interest may be paid out at regular intervals, such as quarterly, semiannually, or annually.

In other cases, it may only be paid out when the fund realizes profits from the sale of its investments.

Conclusion – Carried Interest

Carried interest is a share of the profits of an investment that is given to the investment manager as compensation.

It is often used in the context of private equity and hedge fund management, where the investment manager is responsible for making investment decisions on behalf of the fund.

Carried interest is a component of the overall fee structure used by private equity and hedge funds to compensate the investment manager, and it is typically based on a percentage of the profits generated by the fund.

In private equity, it’s intended to incentivize the investment manager to generate strong returns and is normally paid after the investments in the fund have been sold and the profits have been realized.

In the context of hedge funds that operate in liquid markets, this performance fee may be based on mark-to-market asset values and funds don’t have to liquidate positions in order to achieve their carry.