Carried Interest

What is Carried Interest?

Carried interest is that share of profits that partners of private equity and hedge fund get as compensation. This share is from any profits made. The general partners get this share regardless of whether they have made an initial contribution for any initial funds. Basically, carried interest is a share of a private equity or funds profit that is paid in the form of compensation to fund managers.

Carried interest is also a primary source of Income for general partners. It amounts to a quarter of a fund’s annual profit. The general partner is compensated through an annual Management Fee. This fee is about 2% of the fund’s assets. In the private equity Industry, it has always been believed that carried interest is a fair compensation arrangement. This is because general partners invest a lot of time and effort in developing strategies and increasing the profitability of the business. Much of the time is invested in improving the Efficiency of the company and maximizing the value of the company. This is done by general partners.

The origin of carried interest is found in the 16th century. This was when European ships were crossing Asia and America. The captain of the ship would take 20% of the profit from the goods that were being carried to pay for transport and risk of sailing over the sea.

Carried Interest Taxation

Please note that carried interest acts as a type of performance fee, it motivates the fund’s overall performance. However, one can receive carried interest if the fund’s return meets a certain threshold. Carried interest is a Return on Investment and it will be taxed with Capital gains rate and not income rate. This Tax Rate is much lower than the income tax or self-employment tax.

In many jurisdictions, carried interest is treated as long-term Capital Gain. Long-term capital gains are returns on financial and other investments that have been held for a certain time before being sold. Manager carried interest can be categorised as capital gains even if the return on the manager’s initial investment higher than the Total Return for the asset.