Carried Interest – Definition

Cite this article as:"Carried Interest – Definition," in The Business Professor, updated January 24, 2020, last accessed October 28, 2020, https://thebusinessprofessor.com/lesson/carried-interest-definition/.

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Carried Interest Definition

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.

A Little More on What is Carried Interest

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 fund’s assets. The carry is usually analyzed when the fund’s 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 it’s 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.

References for Carried Interest

http://www.businessdictionary.com/definition/carried-interest.html

https://www.investopedia.com/terms/c/carriedinterest.asp

https://en.wikipedia.org/wiki/Carried_interest

Academic Research on  Carried Interest

New directions in research on venture capital finance, Barry, C. B. (1994). New directions in research on venture capital finance. Financial management, 3-15. This paper surveys recent research on venture capital and suggests directions for future research. There is new empirical evidence in the field, and new theoretical models have resolved some issues. The paper selectively examines recent findings, particularly models and empirical work about the staging of financing, the use of syndicates, the process of screening investments, and the participation by venture capitalists in IPOs. Finally, the paper identifies some of the remaining issues for which new research is needed.

Entrepreneurial finance meets organizational reality: Comparing investment practices and performance of corporate and independent venture capitalists, Dushnitsky, G., & Shapira, Z. (2010). Entrepreneurial finance meets organizational reality: Comparing investment practices and performance of corporate and independent venture capitalists. Strategic Management Journal, 31(9), 990-1017. This paper investigates the effect of compensation of corporate personnel on their investment in new technologies. We focus on a specific corporate activity, namely corporate venture capital (CVC), describing minority equity investment by established‐firms in entrepreneurial ventures. The setting offers an opportunity to compare corporate investors to investment experts, the independent venture capitalists (IVCs). On average, we observe a performance gap between corporate investors and their independent counterparts. Interestingly, the performance gap is sensitive to CVCs’ compensation scheme: it is the largest when CVC personnel are awarded performance pay. Not only do we study the association between incentives and performance but we also document a direct relationship between incentives and the actions managers undertake. For example, we observe disparity between the number of participants in venture capital syndicates that involve a corporate investor, and those that consist solely of IVCs. The disparity shrinks substantially, however, for a subset of CVCs that compensate their personnel using performance pay. We find a parallel pattern when analyzing the relationship between compensation and another investment practice, staging of investment. To conclude, the paper investigates the three elements of the principal‐agent framework, thus providing direct evidence that compensation schemes (incentives) shape investment practices (managerial action), and ultimately investors’ outcome (performance).

A law and finance analysis of hedge funds, Cumming, D., & Dai, N. (2010). A law and finance analysis of hedge funds. Financial Management, 39(3), 997-1026. This paper empirically analyzes the impact of hedge fund regulation on fund structure and performance. The data indicate restrictions on the location of key service providers and permissible distributions via wrappers are associated with lower fund alphas, lower average monthly returns, and higher fixed fees. Furthermore, restrictions on the location of key service providers are associated with lower manipulation‐proof performance measures, while wrapper distributions are associated with lower performance fees. As well, the data show standard deviations of monthly returns are lower among jurisdictions with restrictions on the location of key service providers and higher minimum capitalization requirements.

The Taxation of Carried Interests in Private Equity, Weisbach, D. A. (2008). The Taxation of Carried Interests in Private Equity. Virginia Law Review, 715-764.

The taxation of private equity carried interests: estimating the revenue effects of taxing profit interests as ordinary income, Knoll, M. S. (2008). The taxation of private equity carried interests: estimating the revenue effects of taxing profit interests as ordinary income. Wm. & Mary L. Rev., 50, 115.

The performance of private equity funds, Phalippou, L., & Gottschalg, O. (2008). The performance of private equity funds. The Review of Financial Studies, 22(4), 1747-1776. The performance of private equity funds as reported by industry associations and previous research is overstated. A large part of performance is driven by inflated accounting valuation of ongoing investments and we find a bias toward better performing funds in the data. We find an average net-of-fees fund performance of 3% per year below that of the S&P 500. Adjusting for risk brings the underperformance to 6% per year. We estimate fees to be 6% per year. We discuss several misleading aspects of performance reporting and some side benefits as a first step toward an explanation.

Performance of private equity funds: does diversification matter?, Lossen, U. (2007). Performance of private equity funds: does diversification matter?. Portfolio Strategies of Private Equity Firms: Theory and Evidence, 95-133. There is a large and growing literature analyzing the return of PE investing (Cochrane 2005, Ljungqvist & Richardson 2003a, Ljungqvist & Richardson 2003b, Cumming & Walz 2004, Ick 2005, Jones & Rhodes-Kropf 2003, Kaplan & Schoar 2005, Kaserer & Diller 2004c, Gottschalg et al. 2004).61 The majority of these articles study the relative performance of PE compared to public markets. There is less understanding about the impact of diversification on the performance of PE funds. In this chapter, I try to fill this gap by examining the influence of diversification on the rate of return, intra-fund variation of return, and shortfall probability of PE funds.

Survey evidence on diffusion of interest and information among investors, Shiller, R. J., & Pound, J. (1989). Survey evidence on diffusion of interest and information among investors. Journal of Economic Behavior & Organization, 12(1), 47-66. Questionnaire surveys of institutional and individual investors were undertaken to learn about patterns of communications. It was found that direct interpersonal communications are very important in investor decisions. Questions elicited what fraction of investors were unsystematic and allowed themselves to be influenced by word-of-mouth communications or other salient stimuli. Randomly sampled investors were studied as well as investors in stocks whose price had recently increased dramatically. Contagion or epidemic models of financial markets are proposed in which interest in individual stocks is spread by word of mouth. The survey evidence is interpreted as supporting such models.

The role of private equity group reputation in LBO financing, Demiroglu, C., & James, C. M. (2010). The role of private equity group reputation in LBO financing. Journal of Financial Economics, 96(2), 306-330. This paper investigates whether the reputation of acquiring private equity groups (PEGs) is related to the financing structure of leveraged buyouts (LBOs). Using a sample of 180 public-to-private LBOs in the US between January 1, 1997 and August 15, 2007, we find that reputable PEGs are more active in the LBO market when credit risk spreads are low and lending standards in the credit markets are lax. We also find that reputable PEGs pay narrower bank and institutional loan spreads, have longer loan maturities, and rely more on institutional loans. In addition, while we find that PEG reputation is positively related to buyout leverage (i.e., LBO debt divided by pre-LBO earnings before interest, taxes, and amortization (EBITDA) of the target), and leverage is significantly positively related to buyout pricing, we do not find any direct relation between PEG reputation and buyout valuations. The evidence suggests that PEG reputation is related to LBO financing structure not only because reputable PEGs are more likely to take advantage of market timing in credit markets and but also because PEG reputation reduces agency costs of LBO debt.

Entrepreneurial finance and venture capital markets: Introduction, Cumming, D., & Suret, J. M. (2011). Entrepreneurial finance and venture capital markets: Introduction. European Financial Management, 17(3), 420-422.

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