Carried interest, also commonly referred to as carry, is a financial term used predominantly in the field of private equity, venture capital, and real estate investments. It is a share of profits that general partners (GP) in investment partnerships receive as compensation for managing the partnership and making successful investments.
Carried interest is typically structured as a portion of the profits earned by the partnership, usually after the limited partners (LP) have received a predetermined return on their invested capital, known as the hurdle rate. The GP’s entitlement to carried interest serves as an incentive for them to actively manage the fund, aligning their interests with those of the LPs.
The concept of carried interest is rooted in the principle of risk-sharing. GPs usually invest their own capital into the fund alongside LPs, but carry allows them to participate in the fund’s success beyond the proportionate amount of their initial investment. This arrangement motivates GPs to seek and capture high returns since their compensation is directly linked to the fund’s performance.
Carried interest is typically calculated as a percentage of the profits generated by the partnership above the hurdle rate. The specific terms outlining the distribution of carry are typically agreed upon in the fund’s partnership agreement. Commonly, carried interest is structured with a catch-up provision, which allows the GP to receive a higher percentage of profits until they catch up to their agreed-upon share. After that point, profits are typically distributed on a pro-rata basis between the GP and the LPs.
The tax treatment of carried interest varies across jurisdictions. In the United States, carried interest is typically treated as capital gains for tax purposes. This means that GPs, who are individuals, are taxed at a lower capital gains rate rather than the ordinary income rate, which would apply to traditional compensation. The tax treatment of carried interest has been a topic of much debate and controversy due to concerns about fairness and equity.
Carried interest is an essential component of the compensation structure for investment professionals in private equity, venture capital, and real estate investments. Its connection to performance incentives aligns the financial interests of the GP with the overall success of the partnership and the generated returns for LPs. This structure aims to ensure that GPs are diligent in their investment decisions and actively seek opportunities that yield significant profits.
In conclusion, carried interest represents the share of profits that general partners in investment partnerships receive as a form of compensation. Through this structure, GPs are encouraged to maximize returns for the partnership, as their compensation is directly tied to the fund’s performance. Understanding carried interest is crucial for investors, fund managers, and industry professionals involved in the private equity, venture capital, and real estate sectors, as it forms a fundamental aspect of how these investment partnerships operate.
