Understanding Carried Interest: Mechanics, Benefits, and Controversies

Carried interest is a critical concept in investment management, particularly in private equity, hedge funds, and real estate. It represents the share of profits allocated to general partners (GPs) as compensation for their efforts in managing funds and generating significant returns for limited partners (LPs). This performance-based incentive is celebrated for aligning interests and criticised for its tax implications. One can better appreciate its role in investment structures and the broader financial ecosystem by understanding carried interest.

What is Carried Interest?

Carried interest, often abbreviated as “carry,” is the portion of profits GPs earn in an investment fund, typically as a reward for achieving above-average returns. Unlike management fees, which are fixed and unrelated to fund performance, carried interest is inherently tied to success.

The standard industry practice allocates 20% of the fund’s profits as carried interest, although this percentage can vary depending on agreements. GPs earn this share after LPs receive their initial capital contributions and a predetermined minimum return, known as the hurdle rate. Carried interest serves two primary purposes: incentivising GPs to maximise returns and compensating them for their efforts and risks.

Carried interest originated in maritime ventures centuries ago, where ship captains received a share of the profits for successful voyages. It has evolved into a sophisticated mechanism central to private equity, venture capital, and similar fields.

How Carried Interest Works?

Hurdle Rate

The hurdle rate is a predefined minimum return that the fund must achieve before GPs are entitled to carried interest. This rate safeguards LPs, ensuring they receive a baseline return before sharing profits with GPs. Hurdle rates typically range between 7% and 9%, although variations exist depending on the fund’s structure and investment strategy.

For example, if a fund with a £100 million capital base has a hurdle rate of 8%, LPs are entitled to £8 million in returns annually before carried interest is allocated. Only after this benchmark is met can GPs receive their 20% share of the remaining profits.

Catch-up Clause

Once the hurdle rate is achieved, the catch-up clause comes into play. This provision allows GPs to receive a larger portion of profits until they are fully compensated under the agreed carried interest terms. For instance, in a fund with a 20% carry, the catch-up clause ensures that the GPs’ share of profits “catches up” to align with their entitlement after LPs receive their preferred return.

Waterfall Structures

Waterfall structures dictate how profits are distributed between GPs and LPs. Two primary types are used:

• European waterfall (whole-fund model): Under this structure, carried interest is calculated on the fund’s total performance. GPs only receive their carry once all investments in the fund are exited, and LPs have recovered their initial investments plus the hurdle rate. This approach is conservative and LP-friendly, as it ensures their returns are prioritised.
• American waterfall (deal-by-deal model): In this structure, GPs earn carried interest on each successful deal rather than the entire fund’s performance. While more favourable to GPs, this approach poses a higher risk for LPs, as they may receive uneven returns across different investments.

How is Carried Interest Calculated?

The calculation of carried interest follows a structured process based on pre-agreed terms between general partners (GPs) and limited partners (LPs). This involves determining the fund’s performance, ensuring investor returns, and applying specific allocation rules.

Identifying the Total Fund Profits

The first step is to assess the fund’s total profits. This includes the proceeds from successful investments, such as the sale of assets or portfolio companies, minus the initial investment and associated costs. These profits represent the pool from which carried interest will eventually be drawn.

Example:

• Total investment: £100 million
• Total returns: £120 million
• Fund profit: £20 million

Meeting the Hurdle Rate

Before any carried interest is distributed, the hurdle rate must be satisfied. The hurdle rate is the minimum return that LPs are guaranteed before GPs become eligible for a share of the profits. Only the profits exceeding this benchmark are considered for carried interest distribution.

Example:

• Hurdle rate: 8%
• Guaranteed return to LPs: £8 million (8% of £100 million)
• Remaining distributable profit: £12 million

Allocating Profits Through the Waterfall Structure

Once the hurdle rate is achieved, the profit is distributed according to a pre-defined waterfall structure. This structure governs how profits are split between LPs and GPs:

• In the whole-fund model, all limited partners (LPs) must recoup their initial investment along with the hurdle return across the entire portfolio before general partners (GPs) are eligible to receive carried interest.
• In the deal-by-deal model, general partners (GPs) can earn carried interest on profits from individual deals that meet the hurdle rate, even if other deals within the fund underperform.

Applying the Carried Interest Rate

The agreed carried interest rate, often set at 20%, is then applied to the profits available for distribution. This percentage determines the GPs’ share of the fund’s performance.

Example:

• Remaining profit after hurdle rate: £12 million
• Carried interest rate: 20%
• Carried interest earned by GPs: £2.4 million

Considering Catch-Up Provisions

Some agreements include catch-up provisions, allowing GPs to receive an accelerated portion of profits until their carried interest aligns with the agreed percentage. This ensures GPs are fully compensated for their performance once the hurdle is met.

Final Profit Distribution

After allocating carried interest to GPs, the remaining profits are distributed to LPs. This process ensures both parties receive fair compensation based on the fund’s performance and agreed terms.

Adjustments for Clawbacks or Setbacks

Certain funds also include clawback clauses, which require GPs to return a portion of their carried interest if the overall fund underperforms or fails to achieve projected returns. This mechanism protects LPs from bearing disproportionate losses.

Carried Interest in Different Industries

Private Equity and Venture Capital

Carried interest is most commonly associated with private equity and venture capital, where GPs actively manage companies’ portfolios to achieve substantial returns. In these industries, carried interest is a vital component of the compensation package for fund managers, encouraging them to seek high-value opportunities and maximise profits.

In private equity, carried interest typically arises after successful exits, such as company sales or public offerings. In venture capital, where investments are made in high-risk, early-stage companies, carried interest rewards GPs for identifying and nurturing potential unicorns.

Hedge Funds

Hedge funds use a similar performance-based incentive model, but the application of carried interest differs. In these funds, carried interest is often referred to as a performance fee and is calculated annually. While private equity focuses on long-term investments, hedge funds are more dynamic, involving frequent trades and diverse asset classes.

The carried interest structure in hedge funds ensures managers remain motivated to deliver exceptional annual returns for their investors, even in volatile markets.

Real Estate

In real estate, carried interest, often called “promote” or “promoted interest,” is common in joint ventures between developers and investors. Here, GPs, typically developers, earn carried interest based on the success of property development projects.

Real estate carried interest accounts for developers’ risks, including securing financing, managing construction, and navigating market fluctuations. Promoted interest is distributed after LPs recover their investment capital and achieve a preferred return.

Taxation of Carried Interest

Carried interest is often taxed at favourable long-term capital gains rates rather than higher ordinary income rates. This tax treatment is based on the premise that carried interest represents a share of the fund’s investment returns, akin to owning equity, rather than a salary or wage.

Taxation in the United States

In the U.S., carried interest taxation has been a contentious issue. Historically, it has been taxed as long-term capital gains, with a maximum federal tax rate of 23.8% (20% capital gains tax plus a 3.8% net investment income tax). This rate is significantly lower than the top ordinary income tax rate of 37%.

The Tax Cuts and Jobs Act of 2017 introduced a three-year holding period requirement for carried interest to qualify as long-term capital gains. If investments are held for less than three years, the income is taxed at higher ordinary income rates. While this change impacted hedge funds and similar structures, private equity funds, which often hold investments for longer periods, were largely unaffected.

Debates and Criticisms

Carried interest taxation has faced intense scrutiny. Critics argue that it is a loophole allowing wealthy fund managers to pay lower tax rates than most wage earners. Proponents counter that carried interest reflects entrepreneurial risk-taking and should retain its preferential treatment.

Legislative proposals, such as the “Carried Interest Fairness Act,” aim to tax carried interest as ordinary income. These efforts, however, have faced resistance from the investment industry and policymakers concerned about discouraging economic activity.

Taxation in Other Jurisdictions

In the UK, carried interest is generally taxed as a capital gain but may also attract income tax under certain circumstances. Similar debates about fairness and economic impact have emerged, with regulatory changes occasionally introduced to address public and political pressures.

Controversies Surrounding Carried Interest

Carried interest is a polarising topic in public and political discourse. Its favourable tax treatment has attracted criticism for disproportionately benefiting wealthy individuals, particularly fund managers in private equity, hedge funds, and real estate sectors.

Criticisms

The primary criticism against carried interest lies in its classification for tax purposes. Many argue that it should be treated as earned income rather than investment gains, given that it compensates fund managers for their labour and expertise. This debate has led to repeated legislative proposals in countries like the United States to amend its tax treatment.

Defence of Carried Interest

Proponents of carried interest counter these criticisms by emphasising its role in incentivising entrepreneurial risk-taking. They argue that fund managers often forgo guaranteed salaries and instead rely on carried interest as compensation for performance. They claim that this alignment between risk and reward is essential for fostering innovation and driving economic growth.

Benefits of Carried Interest

Carried interest provides a unique mechanism in the financial industry that fosters collaboration, rewards performance, and aligns interests. Its advantages extend beyond financial gains, touching on the dynamics of teamwork, long-term investment, and innovation.

Incentivising Performance and Innovation

Carried interest serves as a direct motivator for general partners (GPs). Tying compensation to fund performance encourages GPs to adopt innovative approaches and make strategic decisions that maximise profits. Unlike fixed salaries, carried interest requires fund managers to exceed baseline returns, promoting a results-driven mindset.

This incentive system becomes even more critical in high-risk industries such as venture capital. Fund managers are encouraged to identify disruptive technologies and companies with growth potential, benefiting investors and the broader market.

Promoting Long-Term Investment Strategies

One of the defining characteristics of carried interest is its alignment with long-term goals. General partners receive their share of profits only after specific benchmarks like hurdle rates are met. This ensures that managers prioritise sustainable returns rather than short-term gains.

For limited partners (LPs), this focus on the long term translates into stable, predictable returns. Fund managers are incentivised to nurture investments, whether in private equity portfolios or real estate projects, ensuring their value grows consistently over time.

Attracting Top Talent

The promise of carried interest attracts some of the brightest minds to the investment management industry. It offers the potential for significant earnings, particularly in high-performing funds, making it a key differentiator in a competitive job market.

For firms, this means access to skilled professionals capable of managing complex portfolios and navigating volatile markets. For investors, it ensures their assets are handled by individuals motivated to achieve exceptional outcomes.

Challenges and Criticisms

While carried interest offers numerous benefits, it is not without its challenges. From structural complexities to debates over equity and fairness, the mechanism faces significant scrutiny from industry insiders, regulators, and the public.

Complexity in Structuring Agreements

One of the most significant challenges lies in the intricate structure of carried interest agreements. Terms like hurdle rates, catch-up clauses, and multiple layers of waterfall structures require precise definitions and calculations. Misunderstandings or ambiguities in these agreements can lead to disputes between GPs and LPs, undermining trust and cooperation.

For example, in private equity, differing interpretations of performance benchmarks can create friction during profit distributions. Disputes may also arise over the timing of carried interest payouts, especially in multi-deal or multi-fund structures.

Lack of Transparency

Transparency remains a key concern in carried interest arrangements. For LPs, understanding the full financial impact of these agreements can be difficult, particularly when disclosure standards vary widely across funds.

This lack of clarity often leads to misconceptions about how profits are allocated, contributing to broader scepticism about the fairness of carried interest. Enhanced transparency, such as standardised reporting or more transparent communication, could address these concerns while fostering greater investor confidence.

Equity and Fairness Debates

The most contentious issue surrounding carried interest is its perceived inequity. Critics argue that the favourable tax treatment to carried interest disproportionately benefits wealthy fund managers. By taxing carry at capital gains rather than ordinary income rates, the system reinforces income inequality.

On the other hand, defenders of carried interest point to the entrepreneurial risks fund managers take. They argue that carried interest compensates for these risks, rewarding GPs for their unique contributions to fund success. Nonetheless, debates over fairness continue to fuel calls for regulatory reforms.

Public and Political Scrutiny

Carried interest has become a focal point in broader discussions about financial equity. Politicians and public figures often criticise the mechanism, citing it as an example of systemic advantages for the wealthy. This scrutiny can create reputational challenges for investment firms, making it essential for them to address these concerns proactively.

The Broader Significance of Carried Interest

Despite the controversies surrounding carried interest, its importance in the investment industry cannot be overstated. As a performance-based incentive, carried interest drives fund managers to deliver exceptional returns, benefiting GPs and LPs. By aligning the financial interests of these two groups, carried interest fosters a collaborative approach to investment management, ensuring that managers remain committed to achieving long-term success.

Furthermore, carried interest encourages innovation and risk-taking. Fund managers often operate in uncertain and volatile markets, requiring bold decisions and innovative strategies. The potential rewards associated with carried interest incentivise GPs to take calculated risks, ultimately driving growth and value creation across various industries.

Carried interest also plays a vital role in attracting and retaining talent in the investment sector. For many fund managers, the prospect of earning carried interest is a key motivator, making it an essential tool for firms looking to secure top-tier professionals.

FAQs

What is Carry-on Interest?

Carry-on interest, or carried interest, is a share of the profits earned by fund managers (general partners) in investment funds. It acts as a performance incentive, aligning their financial gains with the fund’s success and investor returns.

What Does 20% Carried Interest Mean?

20% carried interest indicates that general partners receive 20% of the fund’s profits after investors recover their initial investment and a preferred return. This percentage is a standard industry benchmark, rewarding managers for exceptional fund performance.

What is a Free Carried Interest?

Free carried interest allocates a fund’s profits to a partner or stakeholder who does not contribute capital. It compensates them for their roles, such as providing expertise, facilitating market access, or regulatory approvals, without requiring financial investment.

What is the Meaning of Free Interest?

Free interest generally refers to an arrangement where a party is entitled to financial benefits or profits from an asset or investment without contributing capital. It is synonymous with free carried interest and rewards non-financial contributions in investment contexts.

What is MOIC?

MOIC, or Multiple on Invested Capital, measures the return on an investment relative to the initial capital invested. Calculated as total investment value divided by the original capital, it shows how much value a fund generates for every dollar or pound invested.