What Is Carried Interest?

Carried interest is a compensation arrangement commonly used in private equity, hedge funds, and venture capital investments. General partners or GPs may receive a percentage of investment profits in the form of carried interest. This is similar to the way that certain stocks pay out profits to shareholders as dividends.

If you’re considering an investment in private equity, a hedge fund, or venture capital, it’s important to understand how carried interest works and what it means for you.

Carried Interest Explained

Carried interest is one of several ways that a general partner may be compensated. General partners are individuals or entities that have a say in how investment funds are managed.

Private equity funds, hedge funds, real estate funds, and venture capital funds can have multiple general partners, each of whom is entitled to a share of the fund’s profits. These profits may be paid out in the form of royalties, capital gains, dividends, or carried interest.

There’s no universal carried interest definition; it’s simply a performance-based fee that’s used to incentivize the fund’s general partners or money managers. Generally, the higher the fund’s profits, the more carried interest the general partners collect.

How Carried Interest Works

Carried interest, often simply called “carry,” works by rewarding an investment fund’s general partners for strong performance.

A typical payout structure is 20% of a fund’s returns, though compensation can vary from one fund to another. Market trends can push payouts higher or lower at any given time. General partners can also collect an annual management fee. For instance, the fee may be 2% of the fund’s assets under management (AUM).

There are some rules to know about when and how carried interest is paid to GPs:

•   For general partners to receive carried interest, fund investors must first receive back the amount of capital they put in. These investors are referred to as limited partners or LPs and how they’re paid depends on the fund’s structure.

•   The fund may need to achieve a minimum rate of return called a “hurdle rate” before any carried interest is paid out to GPs.

•   Carried interest may be withdrawn if a fund underperforms. This may happen if LPs do not receive back the amount of capital they put in.

Here’s what investors should know about carried interest, in a nutshell: When they invest in a private equity fund, hedge fund, or venture capital fund, they (altogether) typically get ~80% of the profits and the GPs get the rest. Knowing how to define carried interest matters if you plan to explore these types of alternative investments for your portfolio.

Tax Treatment of Carried Interest

Taxes on investments affect the level of returns you get to keep. Taxing carried interest is a controversial topic, thanks to a loophole in the Internal Revenue Code (IRC). Section 1061 allows for carried interest held for longer than three years to be taxed at the long-term capital gains rate.

Long-term capital gains are taxed at 0%, 15%, or 20%, depending on your income and household size. Short-term capital gains, meanwhile, are taxed at ordinary income tax rates. For the 2024 tax year, the maximum income tax rate for the highest earners was 37%. Additionally, that will remain the same for the 2025 tax year.

Lawmakers have argued that the current tax rules regarding carried interest allow wealthier taxpayers to sidestep higher tax rates by holding carried interest for longer than three years. Proposed legislation, such as the Carried Interest Fairness Act of 2024, has been pieced together in an attempt to close the loophole and apply ordinary income tax rates on carried interest. But despite being introduced, that particular piece of legislation has (at the time of publication) not advanced.

Carried Interest in Different Contexts

How does carried interest work in different investment settings? How GPs and LPs receive payouts can depend on the type of investment involved.

Private Equity

Private equity refers to an investment in a company that is not publicly listed or traded on a stock exchange. Private equity funds can hold numerous investments in a single basket, offering investors exposure to a range of different companies, including ones that have been delisted from an exchange and ones that have yet to launch an initial public offering (IPO).

In a private equity arrangement, GPs can be compensated with carried interest. Limited partners receive the original capital they invested, along with a share of the profits as dividends, less any fees they pay to own the fund.

Hedge Funds

Hedge funds pool money from multiple investors to make investments. These funds can hold a range of different investments, including stocks, bonds, commodities, real estate, derivatives, land, and foreign currency. Risk is typically higher with a hedge fund, but investors may earn a higher rate of return.

Hedge fund payouts generally follow the same pattern as private equity funds. The GPs receive ~20% of the profits as carried interest, once the fund reaches the minimum hurdle rate. The remaining profits are paid to limited partners as dividends, along with the return of their original capital investment, which they receive first.

Venture Capital

Venture capital funds pool money from multiple investors to fund startups and early-stage companies. This is essentially a form of private equity investment, with some differences.

Investment holding periods may be longer compared to private equity funds and returns are not realized until a company within the fund exits. That can happen if the company decides to go public with an IPO, merges with another company, or is acquired.

Investors can receive the proceeds of an exit as compensation, along with the return of their original capital. General partners receive carried interest, which is again around 20%, but may be higher or lower based on the fund’s performance and its hurdle rate.

Future of Carried Interest

Carried interest has received significant attention from lawmakers and the executive office. Some policymakers have discussed taxing carried interest as ordinary income for those making $400,000 or more, while others would like the loophole closed altogether. Closing the loophole could cut down on tax avoidance among some taxpayers, allowing the federal government to recoup more tax dollars.

HOwever, whether any major changes will be implemented remains to be seen.

What is an alternative to carried interest? One option proposed in the UK is growth shares. Growth shares entitle the shareholder to returns based on future growth. However, this strategy seems on the surface to be very similar to carried interest in terms of the tax benefits it delivers to GPs.

The Takeaway

Carried interest, meaning how general partners get paid, is an important consideration when determining which alternative investments to include in your portfolio. Carried interest is a compensation arrangement under which general partners receive a portion of investment profits, and that’s typically around 20%. This can be a fairly high-level way to invest, of course, so it may be a good idea to get your toes wet with a simple brokerage account before worrying about carried interest. If you have yet to start investing, it’s easy to open a brokerage account online.

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FAQ

Why is carried interest controversial?

Carried interest is controversial because some critics have argued that it allows wealthier taxpayers to benefit from a tax loophole.

How much is carried interest taxed?

In the U.S., carried interest is taxed at the capital gains tax rate. Short-term capital gains are taxed at ordinary income tax rates. Carried interest held for more than three years, however, is subject to the lower long-term capital gains tax rate.

What is the average carried interest?

A typical carried interest payout for general partners is 20% of the fund’s profits. This is paid in addition to a 2% annual management fee. Funds may need to achieve a minimum rate of return before carried interest can be paid out.

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Photo credit: iStock/Andrii Yalanskyi

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