Table of contents
The firm’s general partners get paid more than just their initial investments. This is a form of payment for the services they render. You can think of this as a bonus they receive. The carried interest, or this bonus, is dependent on several factors and also has certain tax obligations.
In this article, we will look at what is carried interest, how it works and what it’s restrictions and tax implications are.
What is carried interest?
The general partners of a hedge fund, private equity, and venture capital get a share of the profits earned by the firm, known as the carried interest. This interest is paid to them for their role as partners instead of their initial investments. It is a performance fee that is aligned with the compensation of the fund’s returns. However, this fund is received only in cases when the firm archives a minimum hurdle rate, the minimum returns.
Additionally, you must note that the carried interest is provided regardless of whether the general partner contributes financially towards the purchase of the fund constituents or not. The name carried interest comes from the fact that the partners who get the funds can reinvest them and carry them forward to the following years until they liquidate the funds.
How does carried interest work?
To understand the functioning of the carried interest vesting, let us understand how the hedge funds and private equity funds operate. These funds mostly have partnerships with a few outside investors called limited partners. The general partners are in charge of managing the funds and business operations.
The general partners are given two kinds of payments, the management fee and the incentive fee. The management fee usually ranges between 1-3% of the asset under management. This fee is paid irrespective of the fund’s performance. However, the carried return is the main source of income for the general partners and accounts for about 20% of the fund’s total returns. As against this, the limited partners are entitled to 80% of the fund’s total profits and a return on their initial investment.
While the management fee is mandatory, the carried interest is provided only when the fund gets the minimum return. The carried interest accounting is considered a long-term capital gain instead of a regular income, thus granting tax benefits.
Tax implications of carried interest
The carried interest is not considered an ordinary income, instead it is categorised as the long term gains when helpd for over 3 years. This income is then taxed at 20% instead of 37% of ordinary income.
However, this is a much-debated topic as several people feel that this provision helps the private equity managers to pay less tax than they should.
The period for considering this long-term capital gain income was initially one year, but this was later extended to three years by the 2017 Tax Cuts and Jobs Act.
What are the restrictions of carried interest?
Now that we know the process of carried interest and its implications let us now look at the restrictions of carried interest private equity. The funds impose these limitations in an attempt to be fair to the limited partners and the general partners. These include:
- Hurdle rate
The huddle rate refers to the minimum returns that the fund must receive to be eligible to pay out the carried interest. The hurdle rate can further be divided into hard hurdle and soft hurdle rates. The hard hurdle rate involves calculating carried interest on the amount above the hurdle rate. As against this, the soft hurdle rate involves calculating the carried interest on the entire profit only after the hurdle rate is accomplished.
- High water mark
This is another restriction according to which the carried interest is prohibited till the previous highest mark is achieved. This measure prevents the investors from paying the carried interest in cases when the returns cross the hurdle rate but then fall below it and then reach higher again.
- Clawbacks
This restriction goes one step ahead and threatens the carried interest that is already received by the general partners. In cases when the fund enjoys a good return and gives the general partner the carried interest but the performance of the fund drops in the future, they have to return a part of the carried interest they have received.
Conclusion
The carried interest is the amount the general partners get for the services they render. This is in addition to the management fee that they get, whether there are good returns or not. On the other hand, the carried interest is provided only in cases when there are minimum returns in the fund that come over the hurdle rate.
These funds can also be carried forward year after year, which gives them the name carried interest and also provides the general partners with a tax advantage.
FAQs
Carried interest is the performance fee that the general partners receive for rendering their services to the fund. However, this amount is provided only when the fund earns the minimum returns necessary.
The performance fee is the amount that the partners get for managing the fund. The carried interest is in fact, a type of performance fee that is provided to the general partners.
The carried interest is considered to be a long-term capital gain instead of a general income. As a result, it is categorised to come under the 20% income tax bracket and not the usual 37% bracket. As a result, the carried interest helps general partners to get a tax benefit.
Yes, there are restrictions imposed on the carried interest to balance the return between the limited partners and the general partners. These limitations include hurdle rate, high water mark and clawbacks.
Hurdle rate is the minum return that the fund must get for providing the general partners with the carried interest. The hurdle rate is further classified into hard and soft hurdle rates.
Leave a Comment