Definition
Carried Interest in Private Equity refers to a share of profits that the fund managers receive as compensation, regardless of whether they contributed any initial funds. This is typically 20% of the fund’s annual profit, but it only becomes available after the fund’s investors have received their initial capital and a pre-set return. It’s a way of incentivizing the fund managers to maximize the fund’s performance.
Key Takeaways
- Carried Interest is a share of the profits of an investment or investment fund that is paid to the investment manager. It’s a form of incentive compensation intended to align the manager’s interests with those of the investors.
- In private equity, the typical carried interest is around 20%, but it’s only paid once the fund has returned all the capital to its investors — this is called the ‘hurdle rate’ and ensures the managers only profit after the investors have been compensated.
- Carried Interest has been a topic of debate, especially regarding its tax treatment. As it’s currently considered a return on investment, it’s taxed at a lower rate than regular income which some argue is an unfair advantage for the finance sector.
Importance
Carried Interest in Private Equity is a crucial term as it serves as a primary source of profit for the fund managers. It is fundamentally a share of the profits of an investment that the general partner of a private equity fund receives as compensation, regardless of the amount they contributed initially.
This arrangement creates a performance incentive as managers share in the upside potential of the portfolio’s companies, driving them to maximize returns. It is critical to align the interests of the managers with those of the investors.
As such, carried interest is a key factor in the financial success of fund managers and is a significant element in structuring private equity investments. Understanding how carried interest works can help investors make more informed decisions about their private equity investments.
Explanation
Carried interest, also known as “carry,” serves as a form of compensation for private equity fund managers for their contribution in managing and realizing returns on the fund’s investments. It is primarily utilized to align the interests of these managers and investors in the fund, incentivizing managers to drive the portfolio to yield high-performance outcomes.
Fund managers typically put in a certain amount of their own money, but the bulk of the fund’s capital comes from third-party investors. Hence, carried interest provides the motivating impetus for portfolio managers to ensure they maximize the profit returns of the funds they manage.
In the world of private equity, the carried interest model is structured as a share of the profits from a successful investment round and is set to a pre-determined percentage, typically around 20%, but it could be higher depending on the fund’s structure and agreement. Portfolio managers only receive this carry upon successful exits from the fund’s investments, which usually occur during a sale or merger of the invested companies.
The core function of carried interest isn’t only about rewarding individual fund managers but it also attributes to pushing for an overall successful performance of the private equity fund. Therefore, the better they manage and grow the investments, the greater their carried interest payout will be.
Examples of Carried Interest in Private Equity
Bain Capital: Bain Capital, a private equity firm co-founded by Mitt Romney, is known to make extensive use of carried interest. When they acquire a company, they typically restructure it to increase its value. Once the company is sold or taken public, the profits are distributed among the firm’s partners. A significant portion of those profits is treated as carried interest.
Blackstone Group: In 2007, Blackstone Group, one of the largest private equity firms, disclosed in an initial public offering filing that their executives made significant income through carried interest. The filing showed carried interest accounted for half of the firm’s total revenue. This form of income allows the firm’s partners to pay at the capital gains tax rate which is lower than the regular income tax rate.
KKR & Co: KKR, a global investment firm, operates on carried interest in a similar way as Bain Capital and Blackstone Group. KKR acquires underperforming companies and implements strategies to improve their operations, growth, and profitability. Once these companies are sold, KKR takes a percentage of the profit as carried interest. The process illustrates how carried interest plays a significant role in the private equity industry.
FAQs About Carried Interest In Private Equity
What Is Carried Interest In Private Equity?
Carried interest, often referred to as carry, is the share of a private equity fund’s profits that is distributed to fund managers. This is usually calculated as a percentage of the fund’s net profit and is a key source of income for fund managers.
How Is Carried Interest Calculated?
Carried interest is typically calculated as a percentage of the fund’s net profits. A common carried interest percentage is 20%, meaning the private equity fund manager would receive 20% of the fund’s profits as carried interest. This usually takes effect after the original investment capital has been returned and a predetermined return threshold has been met.
How Does Carried Interest Impact Investors in a Private Equity Fund?
The carried interest can impact investors as it is a portion of the fund’s profits that will not be distributed to them but will go to the fund managers instead. Though, it is an industry standard and often seen as a performance incentive for the fund managers.
Is Carried Interest Taxed Differently?
Yes, carried interest is typically taxed at the capital gains rate, which is usually lower than the ordinary income tax rate. This is a contentious issue politically, with some advocating that carried interest should be taxed as ordinary income.
How Does Carried Interest Differ From Management Fees?
While both carried interest and management fees are sources of income for fund managers, they serve different purposes. Management fees are designed to cover the operating expenses of managing the fund, while carried interest serves as a performance incentive for fund managers, allowing them to partake in the fund’s profitable upside.
Related Entrepreneurship Terms
- General Partner (GP)
- Limited Partner (LP)
- Private Equity Funds
- Investment Performance
- Cash Distribution
Sources for More Information
- Investopedia: A comprehensive online resource for understanding finance and investing terminology and concepts, including Carried Interest in Private Equity.
- KPMG: An established international network of professional firms providing audit, tax, and advisory services, often publishing in-depth reports on finance and investment subjects such as Carried Interest.
- PE Hub: A community for professionals in private capital, providing industry news, speculations, and in-depth articles on topics like Carried Interest.
- Harvard Business Review: A leading source of insights on business and management, often featuring articles from leading thinkers in business.
