How Does Carried Interest Work? A Financial Breakdown

Carried interest is a share of the profits from an investment fund that is paid to its managers as a performance-based fee. This payment structure is a common feature in alternative investments, including private equity, venture capital, and hedge funds. The purpose of carried interest is to reward fund managers for achieving positive results, which helps align their goals with those of the fund’s investors. While managers also earn a management fee, carried interest often constitutes a significant portion of their long-term compensation.

The Participants in a Private Fund

Private investment funds are structured as limited partnerships involving two types of participants: the General Partner (GP) and the Limited Partners (LPs). The relationship and responsibilities between them are defined in a legal document known as the Limited Partnership Agreement (LPA). This agreement outlines the fund’s strategy, terms, and the roles of each party.

The General Partner is the fund management firm responsible for the fund’s daily operations and investment strategy. GPs have an active role that includes sourcing investment opportunities, conducting due diligence, managing the portfolio, and ultimately deciding when to sell investments. Because of this active management role, the GP assumes unlimited liability for the fund’s debts and obligations.

Limited Partners are the investors who provide the capital for the fund. LPs can be institutional investors like pension funds and university endowments, or high-net-worth individuals. Their role is passive, as they are not involved in day-to-day management, and their financial risk is restricted to the amount of capital they have invested.

The Mechanics of Profit Distribution

A General Partner’s compensation is commonly achieved through the “2 and 20” model, which has two components. The first is a management fee, typically 2% of the fund’s total assets under management. This is paid annually to the GP to cover the costs of running the fund, regardless of its performance.

The “20” in the model refers to the 20% carried interest, which is the GP’s share of the fund’s profits. This performance fee is only paid after the Limited Partners have received a certain level of return. This minimum return threshold is known as the “hurdle rate” or “preferred return,” often set around 8% annually.

The process of distributing profits follows a sequence called a distribution waterfall. First, 100% of distributable proceeds are paid to the LPs until their initial capital contributions are fully returned. Following the return of capital, the LPs continue to receive 100% of the profits until the preferred return has been met.

Once these first two tiers are satisfied, the GP becomes eligible to receive carried interest, and subsequent profits are split. For example, if a fund with a $100 million investment and an 8% hurdle rate generates $130 million, the LPs first get back their $100 million. Next, the LPs receive the first $8 million of profit to satisfy the preferred return. The remaining $22 million is then split, with the GP receiving $4.4 million (20%) and the LPs receiving the final $17.6 million (80%).

Tax Treatment of Carried Interest

For tax purposes, carried interest is treated as a long-term capital gain rather than ordinary income, based on the rationale that it is a return on investment, not a salary for services rendered. The benefit of this classification is that the top federal tax rate for long-term capital gains is 20%, which is significantly lower than the top rate for ordinary income of 37%.

The Tax Cuts and Jobs Act of 2017 introduced a rule under Internal Revenue Code Section 1061 that addresses the holding period for these interests. To qualify for the more favorable long-term capital gains tax rate, the underlying assets that generate the profit must be held for more than three years. This extended the previous holding period requirement of just over one year.

If the holding period for an asset is three years or less, any gain allocated to the GP is recharacterized as a short-term capital gain. Short-term capital gains are taxed at the same rates as ordinary income. Therefore, fund managers are incentivized to pursue longer-term investment strategies to meet the three-year threshold.

Clawback Provisions and Their Function

Fund agreements often include a clawback provision, a protective clause that allows Limited Partners to reclaim carried interest distributions already paid to the General Partner. A clawback is designed to ensure the GP’s total compensation is aligned with the fund’s overall, long-term performance, not just its early successes.

A clawback might be triggered if a fund performs well in its initial years, leading to early carried interest payments, but subsequently experiences losses. If the total profit over the fund’s entire life is lower than what was projected when the initial carry was paid, the GP would have been overpaid. The clawback provision then contractually obligates the GP to return the excess distribution.

The Limited Partnership Agreement determines the exact amount to be returned. Often, the GP’s clawback obligation is capped at the amount of carried interest received, net of any taxes the GP has already paid on that income. For instance, if a GP received a $100 distribution and paid $30 in taxes, the maximum amount the LPs could reclaim would be $70.