Carried interest is central to private equity, venture capital, and hedge fund investments. Serving as a performance-based payment method, it aligns fund managers' incentives directly with investor goals. This guide explains what carried interest is, how it works, its role in investing, and recent debates around taxation.
Carried interest (often called "carry") is the share of investment profits enjoyed by a fund’s general partners (GPs). It is only earned after the fund achieves a pre-set minimum return known as the hurdle rate. Typically, this share is around 20% of profits but varies per the fund’s individual terms.
The term originated in maritime trade during the 16th century. Ship captains earned around 20% of voyage profits to reward the risks and operational costs they undertook, laying the basis for carry's modern financial meaning.
Now, carried interest is a central reward mechanism in investment funds. Unlike management fees, which are fixed recurring payments, carry is paid only when the fund outperforms and surpasses its hurdle rate, incentivizing fund managers to create value.
In PE funds, carried interest encourages alignment between general and limited partners (GPs and LPs). GPs benefit directly when fund investments thrive, promoting a shared commitment to boosting profits.
Imagine a private equity fund with a 20% carry and an 8% hurdle rate. If the fund returns 15%, GPs gain carry on the 7% (profits above the hurdle)—which means they receive about 1.4% overall. It clearly links manager success directly to superior investor returns.
Carry ensures fund managers make decisions focused on generating strong returns. Since compensation depends on profits exceeding the hurdle rate, there is a natural drive for managers to optimize fund performance.
For GPs, carry can deliver significant returns, particularly when managing successful, large-scale funds. The structure recognizes their skills, risk tolerance, and investment insight—key factors in competitive financial markets.
Management fees generate steady income, calculated as a fixed percentage of funds managed. In contrast, carried interest rewards higher performance. The difference: fees cover operational costs, while carry incentivizes managers to exceed performance benchmarks.
As carried interest is often taxed as a long-term capital gain, it usually attracts lower tax rates compared to ordinary income. This reduced tax rate faces criticism from those who view it as unfairly benefiting wealthy fund managers.
Ongoing debates surround the taxation of carried interest, with efforts to reclassify it as ordinary income gaining political traction. Advocates argue this approach is fairer, while opponents caution such a change may reduce investment activities and negatively impact the sector.
Adjustments in taxation could materially alter the incentives for fund managers. With higher taxes on carry profits, managers may reconsider risky, high-reward investment strategies, possibly leading to structural changes in funds and overall investment approaches.
Approaches toward carried interest vary globally. While the U.S. predominantly taxes carry as capital gains, other jurisdictions have their own tax rules and definitions, influencing global investment decisions.
Globally, regulators are increasingly reviewing how carried interest is taxed. The UK, for instance, has considered aligning carried interest taxation more closely with income taxes, echoing a broader international reconsideration of this policy topic.
The conversation around carried interest continues to evolve, with growing emphasis on tax reform and transparency. Stakeholders and regulators are striving to balance the incentive structures that encourage effective investing against the need for equitable taxation.
Future reform efforts around carried interest taxation are likely to emphasize fairness without sacrificing economic growth. Policymakers face the challenge of creating policies that align incentives while supporting robust investments and stable financial markets.
