Carried interest is a share of a private equity or hedge fund’s profits that is paid to the fund’s managers. People often view this money as a performance bonus because the more the fund makes, the more profit there is for the managers to share.
Investment managers typically pay a low tax rate on the carried interest they earn—lower than what most people pay on their salaries. That’s why carried interest is controversial, and some people see it as a tax loophole.
Carried interest can apply to investment funds that are set up as partnerships. Typically, it’s relevant to private equity and hedge funds. Here’s how those work:
There are two types of key players in private equity and hedge funds: general partners and limited partners:
|Who||What they do||What they earn|
|General partners||Manage the fund (i.e., choose and manage investments)||Management fees plus a portion of profits (i.e., carried interest)|
|Limited partners||Invest in the fund (i.e., contribute money)||Returns left over after paying the general partners’ fees|
The amount of carried interest general partners receive can vary but is often about 20% of the fund’s profits. That’s usually paid on top of a management fee, which is often 2% of the fund’s assets.
In addition to receiving their initial investment amount back (unless the fund loses money), investors (i.e., the limited partners) receive the remaining 80% of the fund’s profits.
Here’s what the flow of dollars typically looks like in a private equity or hedge fund:
Carried interest can be a rich deal for fund managers. So many funds put some restrictions on when it can be paid in order to protect the fund’s investors’ interests. Here are some of the features funds often use:
Managers typically continue to receive their management fees no matter how the fund is performing.
Income from carried interest is taxed at the capital gains rate, which is often much lower than the rate for ordinary income.
Some people view this as an unfair advantage for wealthy fund managers. Supporters, however, say that without the incentive of capital gains it would be difficult for startups and other companies to find investors, create jobs, and contribute to the economy.
Carried interest compensates hedge fund and private equity managers for good performance. Only funds that are structured as partnerships are able to pay carried interest. Carried interest is controversial because managers typically pay a low tax rate on these earnings.