Carried interest

Carried interest, or carry, in finance, is a share of the profits of an investment paid to the investment manager in excess of the amount that the manager contributes to the partnership, specifically in alternative investments (private equity and hedge funds). It is a performance fee, rewarding the manager for enhancing performance. Carried interest, or carry, in finance, is a share of the profits of an investment paid to the investment manager in excess of the amount that the manager contributes to the partnership, specifically in alternative investments (private equity and hedge funds). It is a performance fee, rewarding the manager for enhancing performance. The manager's carried-interest allocation varies depending on the type of investment fund and the demand for the fund from investors. In private equity, the standard carried-interest allocation historically has been 20% for funds making buyout and venture investments. Notable examples of private equity firms with carried interest of 25% to 30% include Bain Capital and Providence Equity Partners. In private equity, the distribution of carried interest is directed by a distribution waterfall: to receive carried interest, the manager must first return all capital contributed by the investors and, in certain cases, a previously agreed-upon rate of return (the 'hurdle rate' or 'preferred return') to investors. Private equity funds distribute carried interest to the manager only upon a successful exit from an investment, which may take years. The customary hurdle rate in private equity is 7–8% per annum. In a hedge fund environment, carried interest is usually referred to as a 'performance fee' and because it invests in liquid investments, it is often able to pay carried interest annually if the fund has generated a profit. They have historically centered on 20%, but have had greater variability than those of private equity funds. In extreme cases performance fees reach as high as 44% of a fund's profits but is usually between 15% and 20%. Carried interest is a share of the profits of an investment paid to the investment manager in excess of the amount that the manager contributes to the partnership, specifically in alternative investments i.e., private equity and hedge funds. It is a performance fee rewarding the manager for enhancing performance. The origin of carried interest can be traced to the 16th century, when European ships were crossing to Asia and the Americas. The captain of the ship would take a 20% share of the profit from the carried goods, to pay for the transport and the risk of sailing over oceans. Historically, carried interest has served as the primary source of income for manager and firm in both private equity and hedge funds. Both private equity and hedge funds tended to have an annual management fee of 1% to 2% of committed capital per year; the management fee is to cover the costs of investing and managing the fund. Some have suggested the management fee in hedge funds should be treated as ordinary income rather than capital gains which is treated at a lower tax rate. As the sizes of both private equity and hedge funds have increased, management fees have become a more meaningful portion of the value proposition for fund managers as evidenced by the 2007 initial public offering of the Blackstone Group. The taxation of carried interest has been an issue since the mid-2000s, particularly as the compensation earned by certain investors increased along with the sizes of private equity and hedge funds. Historically, carried interest has been treated as a capital gain for tax purposes in most jurisdictions. The reason for this treatment is that a fund manager would make a substantial commitment of his own capital into the fund and carried interest would represent a portion of the manager's return on that investment. While hedge funds typically trade their investments actively, private equity firms tend to hold their investments for many years. Thus, capital gains from private equity funds typically qualify as long-term capital gains, which receive favorable tax treatment in many jurisdictions. Critics of this tax treatment seek to disaggregate the returns directly related to the capital contributed by the fund manager from the carried interest allocated from the other investors in the fund to the fund manager. Because the manager is compensated with carried interest, the bulk of his income from the fund is taxed as a return on investment and not as compensation for services. This tax treatment originated in the oil and gas industry of the early 20th century, when the actual oil exploration companies, which used financial partners' investments, had their profits taxed at the capital gains rate. This has been lower than the rate for ordinary income for much of the 20th century, in order to encourage risk and entrepreneurship. The logic was that the financial partners’ sweat equity had entailed the risk of loss, if their exploration did not pan out.