Carried Interest - Explained
What is Carried Interest?
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Table of ContentsWhat is Carried Interest?How does Carried Interest Work?Academic Research on Carried Interest
What is Carried Interest?
Carried Interest (also known as carry) refers to the portion of earnings which the general owners of private equity funds and hedge funds receive as a reward when there are profitable investment funds. This method of compensation is meant to inspire the fund manager (general partner) to try to enhance how the fund performs.
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How does Carried Interest Work?
This is the major income source for the hedge fund or private equity's general partner(s). Carried interest ranges from 20% to 25% of the fund's annual earnings. Even though a little management fee is usually charged to every fund, the charges are only meant to cater for the fund's administrative costs. They don't cover the fund manager's compensation. Nevertheless, the general partner should make sure that the first capital which the limited partners contributed is returned alongside an initially agreed return prior to the payment of a carry.
These general partners receive a yearly management fee that's always 2% of the funds assets. The carry is usually analyzed when the funds assets are liquidated or sold to produce the fund with profit. Private equity industries have always considered this to be a fair agreement on compensation since general partners always invest so much time, as well as, resources to make the fund profitable.
The general partner's time is mostly spent in developing a strategy, enhancing the management's efficiency and the portfolio companies, as well as, maximizing the company's value in preparation for IPO or sale. Carried interest isn't automatic. It's only created provided the fund makes a profit that surpasses specific profitability, known as an obstacle. Supposing the return objectives aren't actualized, the general partner won't receive the carried interest while the fund partners will still get their pro-rata share.
Carried interest is subject to a "clawback" supposing the fund doesn't reach its expected targets. For instance, supposing limited partners anticipate a 10% yearly return and the fund gains just 7% for a given period, then part of the general partner's reward might be repaid in order to cover this shortfall. The tax on carry is categorized as capital gains and its taxed at a lower withholding tax rate. Carried Interest critics want it to be grouped as earned income and also taxed at the rate of regular income tax.
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