Carried Interest

Sweetheart Deal

What is carried interest?

Carried interest is the share of profits that go to the general partners of a private equity or hedge fund regardless of how much money they put in.

It is often referred to simply as “carry.”

Since this money is taxed at a lower rate than regular income, it is often seen as an unfair advantage for the millionaire and billionaire fund managers who benefit from it.

Private equity investment basics

In a private equity investment, many people contribute money to a private equity fund, which then uses those dollars to invest in businesses either by purchasing majority ownership or buying the company outright. The fund’s management then implements changes to make the business more profitable before selling it for a profit.

General vs. Limited partners

General Partner—These are the people who raise the money for and manage the Private Equity or Hedge Fund. They pick the companies that the fund invests in and are responsible for improving the companies in the fund’s portfolio.

The general partner has numerous employees at different levels who work together to produce returns for investors. Carried interest is divided between different positions according to seniority. CEOs and managing partners typically receive the most carry.

Limited Partner— A person or entity that contributes investment dollars to the fund but is not responsible for doing any of the work.

How it works

The amount of carried interest general partners receive can vary but is typically about 20% of the total profits. In addition to receiving their initial investment amount, the remaining 80% of profit is divided between the limited partners according to their contributions.

Example:

For an investment of $10 million that earns a profit of $20 million:

wpDataTable with provided ID not found!

Hurdle rate

Typically, a general partner does not receive their carried interest unless the investment produces a certain rate of return for its investors. This minimum return is called the “hurdle rate.” If the returns generated by the investment don’t surpass this level, the general partner doesn’t get paid. This gives them an incentive to make their investment companies as profitable as possible.

Clawback provision

General partners may be required to give back some of their carried interest in certain situations. If the profit from a given investment initially surpasses its hurdle rate but later becomes less profitable, the general partners may be required to give back some of their carry to compensate the limited partners for subpar returns.

For example, if the limited partners expect an 8% annual rate of return, but poor performance down the road reduces the average annual return to only 6%, then some of the general partners’ carry can be “clawed back” to make up the difference.

Taxes

Income from carried interest is taxed at the capital gains rate, which is much lower than the rate for ordinary income. Although people who earn more than $200,000 per year must also pay a 3.8% surtax on investment income, many people argue that treating carried interest as capital gain gives an unfair advantage to the wealthy.

Two and twenty

Because it takes time for an investment to be profitable enough for the general partner to receive carried interest, they are also compensated with an annual management fee. A management fee is equal to a percentage of the total portfolio value, usually 2%. If a private equity fund has $10 million, for example, the general partner will receive $200,000 annually for managing the fund’s investments.

Not all general partners limit themselves to management. Many also invest in the funds they manage, by choice or because they are required to do so as an added layer of accountability. This means they also take home dividends, investment distributions, and noncarry investment profits.

Fun facts

  • The origin of carried interest can be traced to the sixteenth century when European ships were crossing to Asia and the Americas. The captain of the ship would take a 20% share of the profit from the carried goods to pay for the transport and risk of sailing over the ocean.
  • On average, CEOs of private equity firms received $3.4 million in carried interest in 2015.
  • The cofounders of KKR each took home $63 million in carried interest in 2016 alone.
  • Including carry, the CEO of the Blackstone Group, Stephen A. Schwarzman, earned $425 million in 2016 and a whopping $800 million in 2015.

References

  1. http://www.investopedia.com/terms/c/carriedinterest.asp
  2. http://www.taxpolicycenter.org/briefing-book/what-carried-interest-and-how-should-it-be-taxed
  3. http://fortune.com/2016/10/10/presidential-debate-what-is-carried-interest/
  4. http://www.cnbc.com/2014/03/04/cnbc-explains-carried-interest.html
  5. http://www.investopedia.com/video/play/what-carried-interest/
  6. http://www.investopedia.com/articles/investing/102515/carried-interest-loophole-americas-tax-code.asp
  7. http://www.investopedia.com/articles/tax/09/tax-effects-capital-gains.asp
  8. http://www.schwab.com/public/schwab/nn/articles/Taxes-Whats-New
  9. http://news.efinancialcareers.com/uk-en/225363/heres-how-much-youll-be-paid-in-private-equity/
  10. http://www.pressreader.com/canada/windsor-star/20170225/281951722592319

You May Also Like