What Is Carried Interest in Venture Capital?

Carried interest serves as a fundamental performance fee within the venture capital landscape, compensating fund managers for identifying, nurturing, and exiting successful investments. This mechanism aligns the interests of fund managers directly with those of their investors, driving managers to maximize the fund’s financial performance. Unlike operational fees that cover a fund’s running costs, carried interest represents a share of the profits generated from successful investments.

Defining Carried Interest

Carried interest, often referred to simply as “carry,” represents a share of the profits that general partners (GPs) of an investment fund, such as a venture capital fund, receive as compensation. This compensation is paid out after the fund’s investors, known as limited partners (LPs), have received a return on their initial capital and, in many cases, a specified minimum rate of return. Unlike management fees, which are annual charges typically calculated as a percentage of assets under management, carried interest is performance-based and contingent on the fund’s profitability.

The primary purpose of carried interest is to incentivize fund managers to generate high returns for their investors. By linking a substantial portion of the managers’ compensation to the fund’s investment performance, it encourages them to make strategic investment decisions and actively support portfolio companies to achieve successful exits.

Carried interest is typically received by the general partners and their investment professionals who manage the fund. The profits from which carried interest is drawn belong to the limited partners, who are the primary capital providers to the fund. A common arrangement dictates that 80% of the profits go to the LPs, while the remaining 20% is allocated as carried interest to the GPs, though this percentage can vary from 15% to 30% based on the fund’s track record and market conditions.

How Carried Interest is Calculated

The calculation and distribution of carried interest in venture capital funds typically follow a structured process known as a “distribution waterfall.” This mechanism prioritizes the return of capital and profits to limited partners before general partners receive their share.

The waterfall structure involves several sequential stages:

• Return of Capital: 100% of distributed returns go to limited partners until they have fully recovered their initial capital contributions.
• Preferred Return: Also known as a “hurdle rate,” limited partners receive a specified minimum rate of return on their capital before general partners can receive carried interest. This rate is typically 7% to 8%, serving as a benchmark for the fund’s performance.
• Catch-up Provision: After the preferred return is met, general partners “catch up” to their agreed-upon carried interest percentage. During this phase, a significant portion (often 80% to 100%) of subsequent profits are directed to the GPs until their share reaches the target carried interest percentage, commonly 20%.
• Carried Interest Distribution: Finally, the remaining profits are distributed, typically adhering to the agreed-upon split, such as 80% to LPs and 20% to GPs.

A “clawback” provision ensures that if general partners receive more in carried interest than they are ultimately entitled to based on the fund’s overall performance, they must return the excess amount to the LPs. Clawbacks are typically triggered towards the end of a fund’s life, ensuring the agreed-upon profit-sharing ratio is maintained even if early successes are later offset by underperforming investments.

Tax Treatment of Carried Interest

In the United States, carried interest is typically subject to federal income tax at long-term capital gains rates, provided certain holding period requirements are met. This preferential tax treatment applies because carried interest is considered a return on investment, rather than ordinary income for services rendered. Long-term capital gains rates are generally lower than ordinary income tax rates, which can be as high as 37%.

To qualify for these lower long-term capital gains rates, the assets generating the carried interest must typically be held for a minimum of three years. This three-year holding period was codified by Section 1061, extending it from the previous one-year requirement. If the holding period is three years or less, the gain from carried interest is recharacterized as short-term capital gain and taxed at ordinary income rates.

This tax classification contrasts with how management fees are taxed. Management fees, which are annual payments to fund managers for operational costs, are consistently taxed as ordinary income. The distinction in tax treatment between management fees and carried interest is a frequent subject of policy discussions.

Arguments in favor of the current treatment often cite the incentive it provides for long-term investment and risk-taking in ventures that may take many years to mature. Conversely, critics argue that taxing carried interest as capital gains, rather than ordinary income, provides a tax advantage to fund managers that is not available to other service providers. They contend that carried interest is compensation for services and should therefore be taxed at ordinary income rates, similar to wages or bonuses. Investment professionals receiving carried interest would typically report this income on their tax returns, often through partnership K-1 forms, which detail their share of the fund’s income and gains.