Carried interest, or carry, has been a frequent topic in political debates. While some characterize it as a structural tool used to align the interests of private equity funds and their investors, others characterize it as a tax loophole. Regardless of which side of the debate you fall on, as an in-house lawyer you should have a general understanding of how carried interest works.
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An Overview of Private Equity Funds and Carried Interest
Carried interest allocates a portion of the future profits of a private equity fund or other investment fund to the investment professionals that source, evaluate, and manage the fund’s investments. It is intended to incentivize the investment professionals to maximize the fund’s profits and return on investment. This in turn benefits the fund’s investors.
Taking a step back, private equity funds are composed of general partners and limited partners. The general partner is an entity that is formed to make investments for the investors’ benefit. The general partner entity is usually formed as a limited partnership (LP). The limited partners are the investors.
A limited partnership agreement (LPA) governs the relationships between the general partner and the limited partners for a given investment fund. The general partner only earns carried interest to the extent it generates profits above a certain threshold. The carried interest is distributed to the fund’s investment professionals according to the terms of the LPA.
Most private equity funds retain an investment adviser or a management company in order to take care of the day-to-day responsibilities of managing the fund. An investment advisory agreement will be entered into to govern the provision of services and the payment of management fees.
The fund’s limited partners make capital contributions to the private equity fund. This money is then deployed into investment opportunities. Upon exit from an investment, the private equity fund will distribute the net proceeds.
The manner of the distributions of the net proceeds will be outlined in the LPA. The waterfall provision is typically structured so that:
- The initial capital contributions made by the limited partners is returned to them. This return of capital is frequently accompanied by a preferred minimum return. This preferred minimum return, also known as a hurdle rate, is around 8% of the initial capital contribution.
- Following the return of the initial capital contributions to the fund’s investors, the remaining profits are allocated amongst the fund’s investors and the general partner. The general partner typically receives 20% for its carried interest.
Vesting arrangements to pay the carried interest overtime helps to align the incentives of the general partner and the fund’s investors. Vesting the carry increases the likelihood that everyone will stay motivated to maximize the fund’s profits throughout the life of the fund.
The vesting schedule usually tracks the fund’s investment period. There is typically a multi-year vesting period ranging from one to six years. Adjustments are often built into the vesting schedule to account for early departures of certain investment professionals.
Clawback provisions protect investors in circumstances where the general partner is overpaid early in the life of the fund. This can arise in situations where the fund experiences success early on and then underperforms later on.
Carried Interest Structures
Different carry structures are deployed by different private equity funds. In the United States, the deal-by-deal carry model is the predominant structure. Private equity funds based in Europe most commonly have a whole-of-fund carry structure.
Whole-of-fund carry structures spread the carried interest across all of the private equity firm’s investments. This means that net gains and losses are calculated in the aggregate across the firm’s various investments.
In order to reward lower-level investment professionals, sometimes another type of structure called phantom carry is deployed. Phantom carry, also known as synthetic carry, is essentially a bonus pool funded from carried interest dollars tied to the fund’s performance.
Taxation of Carried Interest
Carried interest has attracted attention for its tax advantages. The carried interest granted by the general partner entity is structured as profits interests. The general partner and the investment professionals who receive income with respect to the carried interest can qualify for the long-term, capital gains tax rate. This tax rate is significantly lower than the tax rate for ordinary income.
The Tax Cuts and Jobs Act (TCJA) enacted in 2017 changed the required holding period in order to qualify for the long-term capital gains tax rate. As a result of the TCJA, the required holding period is now three years rather than just one year.