Carried Interest

Definition: Profits paid to the general partners of private equity, hedge funds, or venture capital firms. The general partners are the investment managers of these firms and carried interest is a performance fee that the managers collect for generating large returns.

Most alternative investment funds are set up as partnerships, or other pass through entities, where there are general partners and limited partners. Both typically invest a certain amount of money into the fund, but the limited partners don’t make investment decisions, while the general partners do. There is a fee structure agreed upon at the time of investment that outlines how the funds are distributed. A common structure is 2 and 20. 2 refers to a 2% fee of all the assets under management. This is called the management fee and goes to cover the costs of operating the fund, and is typically paid regardless of performance. The 20 refers to the performance fee and is typically subject to a hurdle rate of 7% to 9%. This means that the fee is only paid if the returns are higher than the hurdle rate.

Now that we have all of that established it is time to introduce carried interest. But first I need to introduce the distribution waterfall, or the method which investment returns are allocated between limited and general partners. First, the returns are distributed to cover each investors initial capital contribution. Next, limited partners receive the returns up to the hurdle rate. Third, general partners receive the the returns up to the hurdle rate. After that the remaining returns are split between the two types of partners based upon a previously agreed upon amount (ex. 20% to GP, 80% to LP). The amount the general partner receives after recouping the initial investment is what is known as carried interest.

Carried interest is typically subject to a long-term capital gains tax with a top rate of 20%, compared to the 37% top rate of ordinary income. To qualify as long-term, the investments need to be held for more than three years. Private equity and hedge funds typically have a holding period of five to seven years, so the carried interest usually qualifies under the long-term capital gains tax.

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