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What is Carried Interest?
Carried Interest is a share of profits that fund managers (especially in private equity, venture capital, and hedge funds) receive as compensation, typically after achieving a minimum return for investors. It aligns the manager’s incentives with investor outcomes.
Definition
Carried Interest is a performance-based share of investment profits allocated to fund managers, usually representing 10–30% of the fund’s gains above a specified threshold.
Key Takeaways
- Serves as incentive compensation for fund managers.
- Commonly structured as 20% of profits after a hurdle rate is met.
- Taxed as capital gains in some jurisdictions, creating ongoing policy debates.
Understanding Carried Interest
Carried interest originated in private equity and venture capital as a way to reward fund managers for delivering strong returns. It is not a salary—managers earn it only when the fund performs well.
Typical fund economics include:
- Management Fee: A fixed annual fee (e.g., 2% of assets under management).
- Carried Interest: A variable share of profits (e.g., 20%).
- Hurdle Rate: Minimum return investors must receive before carry is paid (e.g., 8%).
- Catch-up Provision: Allows managers to receive a larger portion of profits after meeting the hurdle until the agreed split is reached.
Carried interest is paid only after investors receive their capital back and preferred return.
Formula
While structures vary, a simplified formula is:
Carried Interest = (Fund Profits − Preferred Return to Investors) × Carry Percentage
Real-World Example
A venture capital fund returns $200 million on an initial investment of $100 million. After returning capital and meeting the hurdle, remaining profits total $80 million.
With a 20% carry:
Carried Interest = 80M × 20% = $16 million
Fund managers receive this as incentive compensation.
Importance in Business or Economics
Carried interest:
- Encourages managers to maximize investment performance.
- Attracts talent to private markets.
- Aligns fund manager and investor incentives.
It has also sparked global debate over taxation, with critics arguing it should be taxed as ordinary income, not capital gains.
Types or Variations
- European Waterfall: Investors must be fully repaid fund-wide before carry is paid.
- American Waterfall: Carry can be paid on a deal-by-deal basis.
- Tiered Carry Structures: Higher carry percentages for exceeding performance benchmarks.
Related Terms
- Private Equity
- Venture Capital
- Hurdle Rate
- Management Fees
Sources and Further Reading
- Institutional Limited Partners Association (ILPA): https://ilpa.org
- CFA Institute: https://cfainstitute.org
- Investopedia: https://investopedia.com
Quick Reference
- Performance-based compensation in private funds.
- Typically 20% of profits after hurdle rate.
- Aligns fund manager incentives with investor outcomes.
Frequently Asked Questions (FAQs)
Why is carried interest controversial?
Because it is often taxed at lower capital gains rates, critics argue managers receive tax advantages compared to typical wage earners.
Do fund managers earn carried interest even if the fund loses money?
No. Carry is earned only after profits exceed agreed thresholds.
Is carried interest guaranteed?
No. It depends entirely on fund performance, making it a high-risk, high-reward compensation structure.
