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Carried Interest Defined
Carried Interest (or “carry”) is the share of the earnings that the general owners of hedge funds and private equity funds get as compensation when the fund’s investments are profitable. This compensation method is intended to motivate the general partner (fund manager) to work on improving the fund’s performance.
A Little More on Carried Interest
Carried Interest is the main source of income for the general partner(s) of a private equity or hedge fund. Carried interest is typically between 20% and 25% of the annual earnings of the fund. Although a small management fee is generally charged to all funds, these fees are only intended to cover the administrative costs of the fund. They do not cover the compensation to the fund manager. However, the general partner must ensure that the initial capital contributed by limited partners is returned together with a previously agreed return before a carried interest is paid.
The general partners get an annual management fee, which is usually 2% of the fund assets. The carried interest is generally assessed when assets in the fund is sold or liquidated to produce a profit for the fund. The private equity industry has always felt that this is a fair agreement on compensation, as the general partners invest a lot of time and resources in making the fund profitable. Most of the the general partner’s time is invested in strategy development, improving the management efficiency and efficiency of the portfolio companies, and maximizing the value of the company in preparation for sale or IPO.
Carried interest is not automatic. It is only created if the Fund makes a profit that exceeds certain profitability, which is called an obstacle. If the return objectives are not met, the general partner will not receive the carry — while fund partners would still receive their pro rata share. The Carry is also subject to “clawback” if the fund does not hit its projected targets. For example, if limited partners expect an annual return of 10% and the fund earns only 7% for a certain period, part of the general partner’s compensation may be repaid to cover the shortfall.
Tax on carried interest is classified as capital gains and is taxed at a more favorable withholding tax rate. Critics of Carried Interest want it to be classified as earned income and taxed at the regular income tax rate.