What is Carried Interest and How Does it Work

Carried interest is a type of income that venture capital and private equity fund managers earn on the investments they make for their funds.

It's essentially a percentage of the profits earned by the fund, which can be a significant source of income for fund managers.

Carried interest is typically paid out as a percentage of the fund's net asset value, or NAV, which is the total value of the fund's assets minus its liabilities.

A common range for carried interest is between 20% to 30% of the fund's profits, although this can vary depending on the fund and its investors.

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Carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds. It's a performance fee that aligns the general partner's compensation with the fund's returns.

The typical carried interest rate charged to limited partners (LPs) is 20% of the profits from the fund. This means that after the LPs are repaid their original investment amount, the general partners (GPs) will receive 20% of the profits.

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Carried interest is often only paid if the fund achieves a minimum return known as the hurdle rate. This is a threshold that must be met before the GP can receive their share of the profits.

A GP's carried interest percentage is a key component of a fund's partnership agreement, which all LPs become party to when they join the fund. This percentage determines how much of the profits the GP will receive.

Carried interest can be defined in one of two ways: whole fund or deal-by-deal. The whole fund method applies to the entire overall fund-level returns, while the deal-by-deal method applies on a deal-by-deal basis.

Here are the two methods of defining carried interest:

Carried interest is separate from the management fees the GP collects for managing the fund, which are typically 2% of the fund's commitments.

Private equity compensation can be complex, but it's essentially made up of management fees, deal fees, investment returns, base salaries, bonuses, co-investments, and carried interest.

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Management fees are typically 1.5% to 2.0% of the committed fund size, and deal fees are often charged directly to portfolio companies.

Investment returns are a key component of private equity compensation, with firms earning 20% of the profits after a hurdle rate is met.

Base salaries are usually paid monthly, with bonuses being discretionary and based on individual, team, and fund performance.

Co-investments allow employees to put their own money into specific deals and benefit if they perform well.

Carried interest is a performance fee that compensates the GP and managers with a percentage of the profits on the fund's investments. A 20% carried interest is a common performance fee, paid to the general partners of the limited partnership after the initial investment is paid back to the limited partners.

Carried interest can add tens of millions to a Managing Partner's compensation over the life of the fund, but for normal Partners or MDs, it's often much lower, around $1-2 million extra per year.

Here's a rough breakdown of carried interest percentages for different roles:

Keep in mind that these figures are per fund, and total carried interest can be higher if you've participated in multiple funds.

Private equity firms are typically set up as Limited Partnerships between a General Partner (GP) and many Limited Partners (LPs). The GP is the firm itself, and the LPs include institutional investors and high-net-worth individuals. The GP contributes a small percentage of the capital, while the LPs contribute the majority.

The GP's compensation is based on the fund's performance, and it's paid out of the profits after the LPs have received their share. This is known as carried interest, and it's typically 20% of the fund's profits. The GP's initial investment is also returned, plus a share of the profits.

The fund's performance is measured by its IRR (Internal Rate of Return), which is the rate of return on investment. The IRR is calculated over the life of the fund, and it's used to determine how much of the profits go to the GP. The GP's share of the profits is typically 20%, but this can vary depending on the fund's performance.

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Here's a rough breakdown of how the profits are split:

The GP's carried interest is paid out over several years, often 5-10 years, and it's typically back-end-loaded, meaning it's paid out towards the end of the fund's life. This is to ensure that the GP is incentivized to perform well over the long term, rather than just focusing on short-term gains.

In a typical private equity fund, the GP contributes 1-5% of the capital, while the LPs contribute the remaining 95-99%. The GP's carried interest is then based on this small percentage of the capital, but it can still be a significant amount of money if the fund performs well.

Calculating carried interest is a straightforward process. To start, you need to calculate the total fund profits by subtracting the total investment from the final fund value. This is the amount left over after paying back the LPs' principal.

The GP is entitled to receive carried interest if the final fund value exceeds the hurdle rate. In the example, the hurdle rate is 8% and the final fund value is $140m, so the GP is entitled to receive carried interest.

The carried interest is calculated by applying the GP performance fee to the remaining profits. In the example, the GP performance fee is 20% and the remaining profits are $32m. This means the GP earns 20% of $32m, which is $6.4m.

Carried interest is only paid if the fund returns the LPs' principal and exceeds the hurdle rate. If the fund doesn't meet the hurdle rate, the GP does not receive carried interest.

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Carried interest is generally taxed as long-term capital gains based on the GP's tax bracket. The minimum holding period on an investment required to qualify associated carried interest for treatment as a long-term capital gain was increased from one year to three by the 2017 Tax Cuts and Jobs Act.

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Critics argue that taxing carried interest as long-term capital gains allows some of the richest Americans to unfairly defer and lower taxes on the bulk of their income. This has led to proposals in Congress to require the annual reporting of imputed carried interest for immediate taxation as ordinary income.

A carried interest clawback allows a firm to "claw back" a general partner's profits if the amount paid to the general partner is above the agreed-upon amount. For example, if a general partner has been approved to receive 30% carried interest but instead received 35% carried interest, then the limited partners can claw back 5%.

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Carried interest on investments held longer than three years is subject to a long-term capital gains tax with a top rate of 20%. This is significantly lower than the 37% top rate on ordinary income.

The minimum holding period on an investment required to qualify associated carried interest for treatment as a long-term capital gain was increased from one year to three by the 2017 Tax Cuts and Jobs Act. This change was made to prevent wealthy individuals from unfairly deferring and lowering their taxes on the bulk of their income.

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Private-equity and venture-capital fund holding periods typically range from five to seven years. This is much longer than the minimum required three-year holding period.

Some in Congress have proposed requiring the annual reporting of imputed carried interest for immediate taxation as ordinary income. This would eliminate the long-term capital gains tax advantage enjoyed by private equity and venture capital fund managers.

A clawback is a mechanism that allows a firm to recover excess profits paid to a general partner. This can happen if the partner receives more carried interest than agreed upon.

For example, if a general partner is approved to receive 30% carried interest but ends up receiving 35%, the limited partners can claw back the extra 5%. This is a way to prevent partners from taking advantage of the system.

A clawback can be triggered if the firm discovers that the partner's profits exceed the agreed-upon amount. This can happen through audits or other means of review.

For your interest: Principal at Vc Firm Salary

Here are some key points to understand about clawbacks:

The IRS provides guidance on clawbacks through various publications, including the Internal Revenue Service's "Topic No. 409, Capital Gains and Losses" and "Section 1061 Reporting Guidance FAQs". These resources can help firms understand how to implement clawbacks and avoid any potential issues.