When those in the private equity industry talk about carried interest, someone who is not in the know may not understand what is meant by the term, particularly since the word “interest” is generally understood to mean interest payments for a loan. With carried interest, the reality is much different. Carried interest has nothing to do with interest payments.
Ever wonder where the term “carried interest” comes from? It actually goes back to the medieval merchants in Genoa, Pisa, Florence, and Venice. These traders carried cargo on their ships belonging to other people and earned 20% of the profits on the “carried” product.
What Is Carried Interest?
Carried interest is compensation that is received based on performance. The payment has nothing to do with how much capital the manager contributed to the fund. Carried interest is comparable to the stock option compensation that CEOs receive. If the company stock does well, their stock options increase in value. The CEO didn’t pay anything for the option, so they are basically free call options. Carried interest works much the same way. The private equity manager pays nothing for the right to receive the carried interest. If the fund does well, they receive a portion of the profits.
It gets better. Because the profits are related to investments, carried interest is not taxed as regular income. It is taxed as a long-term investment. Why should you care? The maximum tax rate for regular income is about 40%. The maximum rate for long-term capital gains is 20%. Thanks to the tax code, those earning carried interest have their taxes on those earnings cut in half.
This tax treatment has not been without controversy. People who are not beneficiaries of the long-term capital gains tax rates dislike the fact that investment managers might pay a lower tax rate than them, but obviously, those managers are not complaining. It’s just another perk to being employed in the private equity industry.
How Is Carried Interest Structured?
Carried interest is generally 20% of the fund’s profits, but it can be as high as 50% for some elite funds. For starter funds or those suffering from poor performance, carried interest can be in the single digits. Increasing competition in the industry has lowered the average carry rate over the years.
Remember: carried interest is not the only compensation that private equity managers receive. They also charge management fees, which are generally 2%. So even if the fund’s performance is bad for whatever reason, they still get paid. The 2016 Private Equity/Venture Capital Compensation Report provides information on how carry was actually paid to private equity/venture capital professionals in 2015.
Obviously, the goal is to be a top performer in order to maximize pay and career growth. After all, private equity is hard work. Fund managers are heavily involved in strategy, business development, financial management and restructuring, and operational details. Carry is a huge incentive to make sure great fund managers are compensated for their performance.
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