Carried Interest: Definition, Types and its Benefits
Understanding what is meant by the term carried interest can be critical to properly assessing financial performance and risk. Carried interest has become an increasingly important part of many investment structures and can have a significant impact on the overall return on an investment.
Definition of Carried Interest
Carried interest is a form of compensation given to certain investors, usually in private equity and venture capital firms. It is a portion of the profits earned from investments, usually equal to 20 percent of the profits.
In addition, carried interest is usually given to the general partner in a fund or the managing partner in a private equity or venture capital firm. It is also known as a “promote” or “carried interest allocation”. The investor receiving the carried interest typically receives a higher rate of return than the other investors in the fund.
How it works
The way it works is that the manager only keeps the carried interest if the fund generates a profit. If the fund loses money, the manager does not get paid anything. This type of arrangement aligns the interests of the manager with the investors in the fund, as both parties only make money if the fund is successful.
However, carried interest is a controversial topic, as some people argue that it allows managers to make an excessive amount of money. However, supporters of carried interest argue that it is a necessary tool to incentivize managers to take on the risk of investing.
Tax Treatment of Carried Interest
The tax treatment of carried interest is an important consideration for both fund managers and investors. Generally, the tax code considers carried interest to be income and thus it is taxed as ordinary income.
However, there are certain exceptions, such as if the fund manager provides services to the fund for at least three years, in which case the carried interest may be eligible for long-term capital gains treatment, which carries a lower tax rate.
Types of Carried Interest
1. Performance Fee: This type of carried interest is paid to the fund manager after the fund has achieved a certain rate of return. It is based on the return of the fund’s investments above the hurdle rate.
2. Management Fee: This type of carried interest is paid to the fund manager on a regular basis to cover the expenses of managing the fund.
3. Promote Fee: This type of carried interest is paid to the fund manager when the fund has generated a certain rate of return. It is based on the fund’s total return above the hurdle rate.
4. Equity Carried Interest: This type of carried interest is paid to the fund manager when the fund has generated a certain rate of return. It is based on the fund’s total return above the hurdle
The Bottom Line
In conclusion, understanding what carried interest is and how it works is essential for anyone interested in investing or pursuing a career in finance. Carried interest can be a powerful tool for generating significant returns and minimizing taxes. However, it is important to remember that the carried interest structure is highly complex and should be thoroughly researched prior to embarking on any investment endeavor.