Carried Interest: What it is and How it Works

Key Takeaways

• Carried interest gives an investment fund’s general partner the right to share in the fund’s profits. 

• Carried interest is usually treated as long-term capital gains, meaning it is taxed at 20 percent, not as regular income.

• Typically amounting to 20 percent of a fund’s returns, carried interest is the main income source of general partners, who pass such gains on to fund managers.

Investors who seek to enter private equity or venture capital have terminology with which they should be familiar, including “carried interest.”  The term can ultimately affect their personal bottom line, so it is particularly important. But what is carried interest, and how does it work? That and more are covered below.

What is Carried Interest?

Used primarily by those in the $4.5 trillion private equity industry, carried interest is a contractual right that gives a fund’s general partner (GP) the right to share in the fund’s profits. In other words, carried interest is the compensation earned by investment managers on their fund’s performance.

Private equity funds are generally structured as what are called limited partnerships, each with a GP and limited partners (LP). While the general partner establishes, administers, and manages the fund, they also manage the investments. The LPs serve as fund investors.

GPs generally make most of their money through management fees and carried interest, although there is usually other compensation involved such as a salary.  

Note that the term “carried interest” goes back to the 1500s when trans-oceanic ship captains would commonly take 20% “interest” from whatever profits were yielded from whatever cargo they carried.

How Does Carried Interest Work?

Typically amounting to 20% of a fund’s returns, carried interest is the main income source of general partners, who pass such gains on to fund managers.  In addition, some general partners levy a 2% annual management fee.

But before a GP can claim its portion of “carry,” the investors must back the amount of capital they put in the fund.  Note, too, that:

1. Carried interest can be achieved only if the fund gets past a hurdle rate. Unlike the annual management fee, carried interest is earned only if a fund achieves a pre-set minimum return, known as the hurdle rate. Once that is achieved, the fund can start paying the GP part of its performance fee.
2. Carried interest can be forfeited if the fund underperforms. Say a fund targets a 10% annual return but returns just 7% for a period. In that case, investors – a fund’s limited partners – may, under their agreement, “claw back” part of the carried interest paid to the GP when the fund closes to cover the shortfall. In fact, the claw back plank has been used to make the case that carried interest should not be treated as ordinary income. More on the controversy regarding carried interest later. 
3. The percentage is market driven. The percentage of profit that will go to fund managers via carried interest is usually 20%. However, that can vary during the fundraising period depending on the overall market’s performance.

How is Carried Interest Calculated?

Note this example of how carried interest is calculated:

Say XYZ Private Equity Fund has a total investment of $100 million and a hurdle rate of 8%. Its final value after all assets were liquidated was $140 million. Its GP performance fee is 20%. Because the final fund value surpasses the 8% hurdle rate, the general partner is entitled to the carried interest.

The calculations are:

Total fund profits = Final value – Total investment = $140 m – $100 m = 40m

Carried interest = Total profit *Performance fee

= ($40 m) * (20%)

= $8m

The LPs get the remaining profits of $32m.

Is Carried Interest Taxed?

Carried interest is generally private equity fund partners’ chief income source. While such earnings generally place the partners in high tax brackets, carried interest is usually treated as long-term capital gains, meaning it is taxed at 20 percent if held longer than three years. Ordinary income, on the other hand, is subject to a top rate of 37%.

While short-term capital gains tax rates and ordinary income rates are the same, ordinary taxpayers can garner long-term capital gains favor – if an investment is held for more than a year. Such gains are taxed at the lower rate – 20% is the maximum – based on the income tax bracket of the taxpayer. Thus, the carried interest “loophole,” as it is commonly called, is the potential for a zero-percent capital gains tax rate.

Potential Changes to Carried Interest

For more than a decade, U.S. lawmakers have debated “carried interest,” a loophole favored by private equity as well as hedge fund managers and real estate. Some legislative proposals have sought to reform the treatment of carried interest, but to little effect.

1. Tax Cuts and Jobs Act of 2017. As a candidate, Donald Trump pledged to close the carried interest loophole. The Jobs Act sought to weaken the tax preference for carried interest by increasing from one year to three the number of years an asset must be held before it is deemed a long-term capital gain. The act’s effectiveness is limited, however, since many private equity funds generally hold assets for longer than five years.
2. Inflation Reduction Act of 2022. Initial drafts of this legislation contained a plank to scrap the lower taxation of carried interest, but ultimately, that provision was removed from the bill’s final version.

Carried Interest: Investor Perspective Benefits and Drawbacks

As with most things, there are benefits and drawbacks to what is often called the carried interest loophole. As such, the main benefit is that it essentially permits fund managers to generally treat what is functionally their income as tax-favored capital gains. Note that a key justification for carried interest is that it incentivizes managers to assume large risks.

As for drawbacks, carried interest may only be earned if a fund achieves minimum returns. It can also be forfeited should the fund underperform.

Carried Interest: Alternative Investments 

Carried interest can also be earned through some alternative investments, which basically are any assets other than stocks or bonds. Such investments are increasingly popular due to their low correlation to public markets, which reduces overall volatility.

Consider Yieldstreet, a leading platform for private-market investments. In addition to offerings such as art, real estate, private credit, and transportation, the company provides access to private equity and venture capital, alternatives through which carried interest can be earned. Such offerings can give retail investors more options for generating returns outside public markets.

Another benefit of adding alternative investments to portfolios is diversification – the spreading of investments of varying asset classes to mitigate risk and volatility. In fact, diversification is an essential element of any sound investment approach. 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Summary

While controversial, carried interest still lives. In fact, it is the general partner’s primary source of compensation, usually amounting to 20% of a fund’s returns. The gains are then passed on to fund managers as compensation and incentivization.

Remember that there are other ways to take advantage of carried interest, including through alternative investments such as private equity and venture capital.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.