Carried interest

Definition

Carried interest refers to the share of profits that investment managers, particularly in private equity and venture capital, receive as compensation for managing funds. This form of incentive aligns the interests of fund managers with those of their investors, as it is typically earned only when the fund exceeds a predetermined return threshold. Carried interest is crucial in motivating managers to maximize fund performance while also serving as a tax-advantaged income source for them.

5 Must Know Facts For Your Next Test

1. Carried interest typically ranges from 20% to 30% of the profits generated by a fund, incentivizing managers to enhance fund performance.
2. To qualify for carried interest, funds often must surpass a 'hurdle rate', which is the minimum return that must be achieved before managers can earn their share.
3. Carried interest is often taxed at a lower capital gains rate rather than as ordinary income, leading to significant tax savings for managers.
4. The structure of carried interest promotes long-term investment strategies, encouraging managers to hold assets longer to realize greater returns.
5. Recent debates about tax reform have highlighted carried interest, with discussions focusing on whether it should be taxed at the same rate as ordinary income.

Review Questions

• How does carried interest align the interests of fund managers with those of their investors?
  • Carried interest aligns the interests of fund managers with those of their investors by tying the manager's compensation to the performance of the fund. Managers receive a portion of the profits only after reaching a specific return threshold, motivating them to maximize returns for their investors. This structure ensures that both parties benefit from successful investments, fostering a collaborative approach to fund management.
• Discuss the significance of the hurdle rate in the context of carried interest and its impact on fund performance.
  • The hurdle rate is crucial because it sets the benchmark that a fund must exceed before managers can start earning carried interest. This requirement incentivizes fund managers to pursue strategies that generate returns above this threshold, ultimately benefiting investors. By ensuring that managers only profit after achieving specified performance levels, it helps maintain accountability and encourages them to make prudent investment decisions.
• Evaluate the implications of recent legislative discussions regarding the taxation of carried interest and how it could affect private equity and venture capital firms.
  • Recent legislative discussions about taxing carried interest at ordinary income rates instead of capital gains rates could significantly impact private equity and venture capital firms. If enacted, such changes may reduce the attractiveness of this compensation structure for managers, potentially leading to lower investment incentives and altering how funds are structured. This could result in less aggressive growth strategies or even push some firms to seek alternative forms of compensation, impacting overall market dynamics and investment flows in these sectors.

Related terms

Private Equity: Private equity involves investments made directly in private companies or public companies that are intended to be taken private, typically through buyouts.

Venture Capital: Venture capital is a type of private equity focused on investing in early-stage companies with high growth potential in exchange for equity ownership.

Fund of Funds:

A fund of funds is an investment strategy that involves investing in other investment funds, rather than directly in stocks, bonds, or other securities.