Carried Interest

Carried Interest

Key takeaways
* Carried interest is a profit share paid to general partners (GPs) of private equity, venture capital, and some hedge funds to reward performance.
* A common structure is “20% carry” plus an annual management fee (often ~2%).
* Carried interest is typically payable only after investors (limited partners, LPs) receive their capital back and any agreed hurdle rate.
* Tax treatment is contentious: long-term capital gains rates often apply if holding-period rules are met, which can lower tax bills compared with ordinary income.

What is carried interest?

Carried interest is the portion of a fund’s profits allocated to the fund managers (general partners) as compensation for generating returns. It aligns manager incentives with investor outcomes because GPs only earn carry when the fund produces profits above agreed thresholds.

How it works

• Typical split: GPs receive around 20% of profits (the “carry”); LPs receive the remaining 80%, after return of capital and any preferred return.
• Management fee: GPs usually charge an annual management fee (commonly ~2% of assets) to cover operating costs; this is distinct from carried interest.
• Hurdle/preferred return: Many funds require a minimum return to LPs before carry is paid.
• Vesting and timing: Carry often vests over multiple years and is realized as investments are exited.
• Clawback provisions: Some fund agreements let LPs reclaim excess carry paid to GPs if later results mean the GP received more than its agreed share over the life of the fund.

Example (simplified)
1. LPs commit $100M. The fund returns $150M on exit.
2. First the $100M is returned to LPs (capital recovery).
3. Remaining $50M is profit. With 20% carry, the GP receives $10M and LPs receive $40M.

Tax implications

• When investments generating carry are held long enough, carried interest has historically been taxed at long-term capital gains rates (lower than ordinary income rates).
• U.S. rules changed under the 2017 tax law to lengthen the required holding period for certain carried interest to three years for long-term treatment; detailed IRS guidance followed.
• Typical long private capital holding periods (5–7 years) often meet the long-term threshold, so managers frequently benefit from capital gains treatment.
• Debate continues over whether carry should be taxed as ordinary income, with proposals to change reporting or tax treatment to reduce perceived preferential treatment.

Why carried interest is controversial

Critics argue carried interest functions as a tax loophole allowing high-earning fund managers to pay lower tax rates than salaried employees. Supporters counter that carry reflects investment risk and “sweat equity” and that long holding periods justify capital gains treatment.

Clawback explained

A clawback ensures final profit allocations match the agreed economics across a fund’s life. If a GP received more carry earlier than warranted by the fund’s ultimate performance, LPs can reclaim the excess when the fund is wound up. Clawback terms vary by fund and are not universal.

Final thoughts

Carried interest is a core incentive in private investment funds: it rewards managers for producing returns and aligns interests with investors. Its common structure (20% carry plus management fees) is straightforward in principle but can involve complex vesting, hurdle, and tax rules. The tax treatment of carry remains a policy flashpoint because it affects how much tax top fund managers pay relative to ordinary wages.