Carried Interest

Introduction:

Carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds. 

Unlike an initial investment in the fund, carried interest is due to general partners based on their role. It serves as a performance fee that aligns the general partner’s compensation with the fund’s returns. 

Typically, carried interest is only paid if the fund achieves a minimum return known as the hurdle rate. Furthermore, it usually qualifies for treatment as a long-term capital gain, resulting in a lower tax rate compared to ordinary income.

Key Takeaways:

  • Carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds.
  • It is due to general partners based on their role and serves as a performance fee.
  • Payment of carried interest is contingent upon the fund achieving a minimum return known as the hurdle rate.
  • Carried interest usually qualifies for treatment as a long-term capital gain, resulting in a lower tax rate.

How it Works:

Carried interest serves as the primary source of compensation for general partners, typically amounting to 20% of a fund’s returns. 

Unlike the annual management fee, carried interest is only earned if the fund achieves a pre-agreed minimum return. It can also be forfeited if the fund underperforms. 

Additionally, the portion of carried interest that a general partner receives typically vests over a number of years.

Key Components:

  • General Partners: The recipients of carried interest, general partners manage and oversee private equity, venture capital, and hedge funds.
  • Hurdle Rate: Carried interest is only paid if the fund achieves a pre-agreed minimum return, known as the hurdle rate.
  • Vesting: The portion of carried interest that a general partner receives is often subject to vesting, meaning it becomes fully owned over a period of time.

Benefits:

  • Alignment of Interests: Carried interest aligns the compensation of general partners with the fund’s returns, encouraging them to work towards maximizing profits.
  • Tax Advantage: Carried interest usually qualifies for treatment as a long-term capital gain, resulting in a lower tax rate compared to ordinary income.
  • Performance-Driven: General partners only receive carried interest if the fund achieves a predetermined minimum return, incentivizing them to carefully select and manage investments.

Takeaway:

Carried interest is a performance fee earned by general partners of private equity, venture capital, and hedge funds. It aligns their compensation with the fund’s returns and is typically only paid if the fund achieves a minimum return. 

As a long-term capital gain, carried interest enjoys a lower tax rate compared to ordinary income. 

Understanding the structure and benefits of carried interest is important for those interested in the workings of alternative investment funds.

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Sources:

https://www.investopedia.com/terms/c/carriedinterest.asp