What Is a Carried Interest and How Does It Work?

Carried interest is a concept frequently encountered in the financial world, particularly within private investment funds such as private equity, venture capital, and hedge funds. While it represents a significant form of compensation for investment managers, this financial mechanism is designed to align the interests of fund managers with those of their investors, serving as a performance-based incentive.

Defining Carried Interest

Carried interest is fundamentally a share of the profits generated by an investment fund, which is paid to the fund’s general partners or investment managers. It becomes payable only after the limited partners have received back their initial capital contributions and after a predetermined minimum return, often called a preferred return or hurdle rate.

The rationale behind carried interest is to directly tie a fund manager’s earnings to the investment performance of the fund. The most common arrangement for carried interest follows an 80/20 split, where 80% of the profits go to the limited partners, and 20% is allocated to the general partners as carried interest.

How Carried Interest is Calculated

Calculating carried interest involves several specific financial mechanisms that dictate when and how fund managers receive their share of profits. The fund’s offering documents outline how carried interest is calculated and distributed.

A central component in this calculation is the preferred return, also known as a hurdle rate. This is a minimum rate of return that limited partners must achieve on their investment before the general partners can begin to take their carried interest.

Funds also often include a capital clawback provision. This mechanism provides a way for limited partners to recover carried interest already paid to general partners if the fund’s overall performance declines later in its life, falling below the preferred return threshold.

The distribution of carried interest can follow different approaches, primarily deal-by-deal or fund-as-a-whole. Under a deal-by-deal (American-style) approach, general partners may receive carried interest after each successful investment exit, even if the entire fund has not yet returned all capital to limited partners. Conversely, the fund-as-a-whole (European-style) approach requires the entire fund to return all capital and meet the preferred return for limited partners before any carried interest is distributed from any deal.

These distribution methods are often structured within a “distribution waterfall,” which is a tiered system outlining the sequence in which cash flows from a fund are distributed. The typical tiers involve returning initial capital to limited partners, followed by satisfying the preferred return, and then, if applicable, a “catch-up” tranche for general partners, before the final allocation of carried interest.

Distinguishing Carried Interest from Other Compensation

Carried interest stands apart from other forms of compensation commonly found within investment funds due to its performance-based nature. Understanding these distinctions clarifies its unique role in the financial ecosystem.

One significant difference is with management fees. Management fees are annual charges, often calculated as a percentage of the assets under management (AUM) or committed capital, regardless of the fund’s investment performance. These fees, which range from 1% to 2% of AUM, cover the fund’s operational expenses, including salaries and administrative costs. Unlike carried interest, management fees provide a stable revenue stream for the fund’s general partners, even if the fund does not generate profits.

Carried interest is also distinct from limited partners’ capital contributions. Limited partners invest their own capital into the fund, expecting a return on that investment. Carried interest, however, is a share of the fund’s profits paid to general partners for their management services and expertise, not a return on their personal capital invested in the fund. While general partners may also contribute a small percentage of capital to the fund, carried interest is calculated on the overall profits, separate from the return on their invested capital.

Carried interest differs from regular salaries or performance bonuses that fund employees might receive. Salaries and traditional bonuses are fixed or discretionary payments tied to individual or company-wide performance metrics, but not directly linked to the specific profit-sharing structure of the fund’s investments. Carried interest, conversely, is a share of the fund’s investment profits, serving as a direct incentive for the fund’s investment success rather than general employment compensation.

Taxation of Carried Interest

The taxation of carried interest in the United States is a complex aspect, often subject to public discussion, due to its potential for preferential tax treatment compared to ordinary income. Investment funds are frequently structured as pass-through entities, such as partnerships, meaning the fund itself generally does not pay corporate income tax. Instead, the income and gains generated by the fund “pass through” to the individual partners, who then report and pay taxes on their share at their individual tax rates.

A significant feature of carried interest taxation is its potential to be treated as long-term capital gains. If the underlying assets generating the profits are held for a specific duration, more than three years, the income allocated as carried interest may qualify for lower long-term capital gains tax rates. Under current U.S. tax law, this can result in a top federal tax rate of 20%, plus a 3.8% net investment income tax, totaling 23.8%. This is lower than the top federal ordinary income tax rate, which can reach 37%.

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced Internal Revenue Code Section 1061, which specifically addresses the holding period for carried interests. This section requires a three-year holding period for assets to qualify for long-term capital gains treatment for carried interest, an increase from the previous one-year requirement for general capital gains. If the assets are held for three years or less, the income from carried interest may be recharacterized and taxed at higher ordinary income rates. This three-year rule primarily applies to profits interests in investment vehicles like hedge funds, private equity funds, and venture capital funds.

The rationale for this capital gains treatment stems from the argument that carried interest is a return on the general partner’s expertise and the risks taken in managing the capital, rather than merely compensation for services rendered. This perspective views the general partner as a co-investor who contributes specialized knowledge and effort, making their share of profits akin to an investment return. Recipients of carried interest receive an IRS Schedule K-1 from the partnership, which details their share of the fund’s income, including any capital gains or ordinary income. This form is important for partners to accurately report their income on their individual federal tax returns.