Carried Interest Definition, Explanation and Calculation
Carried interest is a performance fee paid to a manager or partner for making an investment happen. It is the share of profits from the proceeds of an investment paid to the manager or general partner over and above their fee.
Also called carry in finance, carried interest can be paid on a variety of investments such as private equity, hedge funds, and venture capital. Let us take a deeper look at the carried interest definition, examples, and how is carry calculated.
What is the Definition of Carried Interest?
A carried interest is a share of the profits from the proceeds of an investment paid to the general partners or managers over and above their regular fees. It is usually only paid when the investment garners a minimum preset return.
It is paid to the partners or managers based on their role in making the deal happen and aligns with their compensation as well.
Carried Interest Definition
What is known as carry in finance is the performance fees paid to general partners when an investment makes more than the minimum expected return on it. The minimum expected return is called a hurdle fee, crossing which partners become entitled to carried interest.
Carried interest is usually termed a return on investment and therefore, it is taxed as a capital gain instead of direct or normal income. This allows it to be taxed at a lower rate. It can lead to investors exploiting the carried interest loophole. Carried interest loophole will be explained below in detail.
How does Carried Interest Work?
Now that we have covered the carried interest definition, let us take a look at the carried interest calculation. The carried interest formula states that investors receive around 20% of the return on the investment after all contributing partners have been paid the sum they paid. This would be counted as 1X of their investment.
To understand this in simple words with a carried interest example, let's assume that three partners contribute $20 each for investment and set the hurdle fee at $200. They earn $300 on the investment. After taking out their $20 apiece, the net return is $220. The carried interest would be 20% of this amount, which is equal to $44.
How is Carried Interest Tax Calculated?
Carried Interest is taxed as a capital gain as it is classified as gains from a private equity fund. This means it is taxed in a way any gain from an investment would be taxed, such as stocks and bonds. It is lower than the tax on a regular income.
Tax on carried interest being lower than the tax on regular income paves way for a loophole many investors routinely exploit to earn more and pay fewer taxes. It is called a carried interest loophole, as mentioned above.
If you are wondering what is carried interest loophole, it is investors claiming big portions of their earnings or compensations as investment gains. This allows them to pay a lower tax, contributing to wealth inequality among taxpayers.
Carried Interest vs Performance Fee
Investors often get confused about the difference between the carried interest and performance fee. They are both one and the same thing. It is also known as incentive fees or promote interest.
It has earned itself these names because it is only paid when the investment brings a substantial amount of return that is more than the minimum return set.
Conclusion
Carried interest is an incentive fee paid to general partners of an investment when said investment earns more than a certain amount decided beforehand. It is usually 20% of the net return after the original investment of every partner is deducted from the gross return.
Carried interest can be earned on private equity, hedge funds and venture capital. It is classified as a capital gain as gain from a private equity fund. It is therefore taxed at a lower rate than regular income.
It is a good source of income if you work toward executing big deals. You can earn a good profit that you will not have to pay a hefty tax on. You can also think of it as an additional source of income.
FAQs
Who gets carried interest?
The general partners of the investment receive carried interest. They can be investors or managers who make the deal happen and earn interest up to their investment in the deal.
Why is it called carried interest?
It is called 'carried interest' because it is carried from year to year until a cash payment is made to the general partner.
How do you calculate carry?
First, take out the amount the partners have invested. The general partners receive around 20% of the net amount left as carried interest.
How is carried interest distributed?
Carried interest is distributed after a period of years. It may be distributed within one year on rare occasions but it usually takes anywhere from three to six years.