Carried interest
Encyclopedia
Carried interest or carry, in finance, specifically in alternative investment management, is a share of the profits of a successful investment partnership
that is paid to the investment manager
of the partnership (a private equity fund
or hedge fund
) as a form of compensation that is designed as an incentive to the manager to maximize performance of the investment fund.
In a hedge fund environment, carried interest is usually referred to as a "performance fee".
A manager's carried-interest allocation is in addition to any investment that the manager may have in the private equity fund or hedge fund
.
In private equity
, in order to receive carried interest, the manager must first return all capital contributed by the investors, and, in certain cases, the fund must also return a previously agreed-upon rate of return (the "hurdle rate") to investors. Hedge funds often are able to pay carried interest annually, because they invest in liquid investments, whereas private equity funds only upon exiting an investment, which may take years.
The usual hurdle rate in private equity is 8%.
The manager's carried-interest allocation will vary depending upon the type of investment fund and the demand for the fund from investors. In private equity, the standard carried-interest allocation historically has been twenty percent for funds making buyout and venture investments. Carried-interest rates - performance fees - among hedge funds have historically also centered around twenty percent, but have had greater variability than those of private equity funds, in extreme cases reaching as high as fifty percent of a fund's profits, although usually it is between 15% and 20%.
As the sizes of both private equity and hedge funds have increased, management fees have become a more meaningful portion of the value proposition for fund managers as evidenced by the 2007 initial public offering
of the Blackstone Group
.
and the British Venture Capital Association (BVCA) entered into an agreement which provided that in most circumstances gains on carried interest were not taxed as income.
The Finance Act 2003
widened the circumstances in which investment gains were treated as employment-related and therefore taxed as income. In 2003 the Inland Revenue and the BVCA entered into a new agreement which had the effect that, notwithstanding the new legislation, most carried-interest gains continued to be taxed as capital gains and not as income. Such capital gains were generally taxed at ten percent as opposed to a forty percent rate on income.
In 2007, the favourable tax rates on carried interest attracted political controversy. It was said that cleaners paid tax at a higher rate than the private-equity executives whose offices they cleaned. The outcome was that the capital-gains tax rules were reformed, increasing the rate on gains to eighteen percent, but carried interest continued to be taxed as gains and not as income.
of an interest in future profits. Instead, the partner is taxed as the partnership earns income. In the case of a hedge fund, this means that the partner defers taxation on the income that the hedge fund earns, which is typically ordinary income (or possibly short-term capital gains), due to the nature of the investments most hedge funds make. Private equity funds, however, typically invest on a longer horizon, with the result that income earned by the funds is long-term capital gain, taxable to individuals at a maximum fifteen percent rate. Because the twenty-percent profits share typically is the bulk of the manager's compensation and because this compensation can reach, in the case of the most successful funds, enormous figures, concern has been raised, both in the U.S. Congress
and in the media, that managers are taking advantage of tax loopholes to receive what is effectively a salary without paying the ordinary thirty-five percent marginal income tax rates that an average person would have to pay on such income. To address this concern, U.S. Representative
Sander M. Levin
introduced H.R. 2834, which would eliminate the ability of persons performing investment-adviser or similar services to partnerships to receive capital-gains tax treatment on their income. However, the U.S. Treasury Department
has suggested, both in testimony before the U.S. Senate Finance
Committee
and in public speaking engagements, that altering the tax treatment of a single industry raises tax policy concerns, and that changing the way partnerships in general are taxed is something that should only be done after careful consideration of the potential impact.
U.S. Representative Charles B. Rangel
included a revised version of H.R. 2834 as part of the "Mother of All Tax Reform" and the 2007 House extenders package. A line item on taxing carried interest at ordinary income rates was included in the Obama Administration's
2008 Budget Blueprint. On April 2, 2009, Congressman Levin introduced a new and substantially revised version of the carried interest legislation as H.R. 1935.
Partnership
A partnership is an arrangement where parties agree to cooperate to advance their mutual interests.Since humans are social beings, partnerships between individuals, businesses, interest-based organizations, schools, governments, and varied combinations thereof, have always been and remain commonplace...
that is paid to the investment manager
Management
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...
of the partnership (a private equity fund
Private equity fund
A private equity fund is a collective investment scheme used for making investments in various equity securities according to one of the investment strategies associated with private equity....
or hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
) as a form of compensation that is designed as an incentive to the manager to maximize performance of the investment fund.
In a hedge fund environment, carried interest is usually referred to as a "performance fee".
A manager's carried-interest allocation is in addition to any investment that the manager may have in the private equity fund or hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
.
In private equity
Private equity
Private equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange....
, in order to receive carried interest, the manager must first return all capital contributed by the investors, and, in certain cases, the fund must also return a previously agreed-upon rate of return (the "hurdle rate") to investors. Hedge funds often are able to pay carried interest annually, because they invest in liquid investments, whereas private equity funds only upon exiting an investment, which may take years.
The usual hurdle rate in private equity is 8%.
The manager's carried-interest allocation will vary depending upon the type of investment fund and the demand for the fund from investors. In private equity, the standard carried-interest allocation historically has been twenty percent for funds making buyout and venture investments. Carried-interest rates - performance fees - among hedge funds have historically also centered around twenty percent, but have had greater variability than those of private equity funds, in extreme cases reaching as high as fifty percent of a fund's profits, although usually it is between 15% and 20%.
Carried interest and management fees
Historically, carried interest has served as the primary source of income for the manager in both private equity and hedge funds. Both private equity firms and hedge funds tended to have a small annual management fee (one to two percent of committed capital); the management fee is meant primarily to cover the costs of investing and managing the fund rather than for meaningful wealth creation for the manager.As the sizes of both private equity and hedge funds have increased, management fees have become a more meaningful portion of the value proposition for fund managers as evidenced by the 2007 initial public offering
Initial public offering
An initial public offering or stock market launch, is the first sale of stock by a private company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises...
of the Blackstone Group
Blackstone Group
The Blackstone Group L.P. is an American-based alternative asset management and financial services company that specializes in private equity, real estate, and credit and marketable alternative investment strategies, as well as financial advisory services, such as mergers and acquisitions ,...
.
United Kingdom
The Finance Act 1972 provided that gains on investments acquired by reason of rights or opportunities offered to individuals as directors or employees were, subject to various exceptions, taxed as income and not capital gains. This may strictly have applied to the carried interests of many venture-capital executives, even if they were partners and not employees of the investing fund, because they were often directors of the investee companies. In 1987, the Inland RevenueInland Revenue
The Inland Revenue was, until April 2005, a department of the British Government responsible for the collection of direct taxation, including income tax, national insurance contributions, capital gains tax, inheritance tax, corporation tax, petroleum revenue tax and stamp duty...
and the British Venture Capital Association (BVCA) entered into an agreement which provided that in most circumstances gains on carried interest were not taxed as income.
The Finance Act 2003
Finance Act 2003
The Finance Act 2003 is an Act of the Parliament of the United Kingdom prescribing changes to Excise Duties, Value Added Tax, Income Tax, Corporation Tax, and Capital Gains Tax...
widened the circumstances in which investment gains were treated as employment-related and therefore taxed as income. In 2003 the Inland Revenue and the BVCA entered into a new agreement which had the effect that, notwithstanding the new legislation, most carried-interest gains continued to be taxed as capital gains and not as income. Such capital gains were generally taxed at ten percent as opposed to a forty percent rate on income.
In 2007, the favourable tax rates on carried interest attracted political controversy. It was said that cleaners paid tax at a higher rate than the private-equity executives whose offices they cleaned. The outcome was that the capital-gains tax rules were reformed, increasing the rate on gains to eighteen percent, but carried interest continued to be taxed as gains and not as income.
United States
Because the manager is compensated with a profits interest in the fund, the bulk of his or her income from the fund is taxed, not as compensation for services, but as a return on investment. Typically, when a partner receives a profits interest (commonly referred to as a "carried interest"), the partner is not taxed upon receipt, due to the difficulty of ascertaining the present valuePresent value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of an interest in future profits. Instead, the partner is taxed as the partnership earns income. In the case of a hedge fund, this means that the partner defers taxation on the income that the hedge fund earns, which is typically ordinary income (or possibly short-term capital gains), due to the nature of the investments most hedge funds make. Private equity funds, however, typically invest on a longer horizon, with the result that income earned by the funds is long-term capital gain, taxable to individuals at a maximum fifteen percent rate. Because the twenty-percent profits share typically is the bulk of the manager's compensation and because this compensation can reach, in the case of the most successful funds, enormous figures, concern has been raised, both in the U.S. Congress
United States Congress
The United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....
and in the media, that managers are taking advantage of tax loopholes to receive what is effectively a salary without paying the ordinary thirty-five percent marginal income tax rates that an average person would have to pay on such income. To address this concern, U.S. Representative
United States House of Representatives
The United States House of Representatives is one of the two Houses of the United States Congress, the bicameral legislature which also includes the Senate.The composition and powers of the House are established in Article One of the Constitution...
Sander M. Levin
Sander M. Levin
Sander Martin Levin, generally known as Sandy Levin, is the U.S. Representative for , serving since 1983, and the ranking Democrat on the House Ways and Means Committee...
introduced H.R. 2834, which would eliminate the ability of persons performing investment-adviser or similar services to partnerships to receive capital-gains tax treatment on their income. However, the U.S. Treasury Department
United States Department of the Treasury
The Department of the Treasury is an executive department and the treasury of the United States federal government. It was established by an Act of Congress in 1789 to manage government revenue...
has suggested, both in testimony before the U.S. Senate Finance
Committee
United States Senate Committee on Finance
The U.S. Senate Committee on Finance is a standing committee of the United States Senate. The Committee concerns itself with matters relating to taxation and other revenue measures generally, and those relating to the insular possessions; bonded debt of the United States; customs, collection...
and in public speaking engagements, that altering the tax treatment of a single industry raises tax policy concerns, and that changing the way partnerships in general are taxed is something that should only be done after careful consideration of the potential impact.
U.S. Representative Charles B. Rangel
Charles B. Rangel
Charles Bernard "Charlie" Rangel is the U.S. Representative for , serving since 1971. A member of the Democratic Party, he is the third-longest currently serving member of the House of Representatives. As its most senior member, he is also the Dean of New York's congressional delegation...
included a revised version of H.R. 2834 as part of the "Mother of All Tax Reform" and the 2007 House extenders package. A line item on taxing carried interest at ordinary income rates was included in the Obama Administration's
Presidency of Barack Obama
The Presidency of Barack Obama began at noon EST on January 20, 2009 when he became the 44th President of the United States. Obama was a United States Senator from Illinois at the time of his victory over Arizona Senator John McCain in the 2008 presidential election...
2008 Budget Blueprint. On April 2, 2009, Congressman Levin introduced a new and substantially revised version of the carried interest legislation as H.R. 1935.
See also
- Performance feePerformance feeA performance fee is a fee that an investment fund may be charged by the investment manager that manages its assets, calculated by reference to the increase in the fund's net asset value , which represents the value of the fund's investments...
- Taxation of private equity and hedge fundsTaxation of private equity and hedge fundsPrivate equity funds and hedge funds are private investment vehicles used to pool investment capital, usually for a small group of large institutional or wealthy individual investors. They are subject to favorable regulatory treatment in most jurisdictions from which they are managed, which allows...