Carried interest

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Carried interest or carry, in finance, is a share of the profits of a successful partnership that is paid to the 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. 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

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 20% for funds making buyout and venture investments, although in recent years more firms^[1] Carried interest rates among hedge funds have historically also centered around 20%, but have had greater variability than private equity funds, occasionally reaching as high as 50% of a fund's profits.

Contents 1 Carried interest and management fees 2 Taxation of carried interest 2.1 United States 2.2 United Kingdom 3 See also 4 References

[edit] 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 (1-2% 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 of the Blackstone Group.

[edit] Taxation of carried interest

[edit] United States

Because the manager is compensated with a profits interest in the fund, the bulk of its 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 value of an interest in future profits.^[2] 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 15% rate. Because the 20% 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 Congress and in the media, that managers are taking advantage of tax loopholes to receive what is effectively a salary without paying the ordinary 35% marginal income tax rates that an average person would have to pay on such income. To address this concern, Congressman 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. ^[3] However, the Treasury Department has suggested, both in testimony before the Senate Finance Committee^[4] and in public speaking engagements,^[5] 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.

Congressman 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.^[6] On April 2, 2009, Congressman Levin introduced a new and substantially revised version of the carried interest legislation as H.R. 1935.^[7]

[edit] 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 Revenue and the British Venture Capital Association 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.^[8] Such capital gains were generally taxed at 10%, as opposed to a 40% rate on income.

In 2007 the favourable tax rates on carried interest attracted political controversy.^[9] It was said that cleaners paid tax at a higher rate than the private equity executives whose offices they cleaned.^[10] The outcome was that the capital gains tax rules were reformed, increasing the rate on gains to 18%, but carried interest continued to be taxed as gains and not as income.^[11]

[edit] See also

• Taxation of private equity and hedge funds
• Private equity
• Private equity firm
• Private equity fund
• Hedge fund

[edit] References

v • d • e Topics on private equity and venture capital Basic investment types Bootstrap funding · Venture · Buyout · Mezzanine · Growth · Secondaries · Equity co-investment History History of private equity and venture capital · Early history of private equity · Private equity in the 1980s · Private equity in the 1990s · Private equity in the 2000s Terms and concepts Buyout Financial sponsor · Management buyout · Divisional buyout Venture Seed money · Startup company · Angel investor · Venture capital financing · Pre-money valuation · Post-money valuation · Venture round · Venture debt Structure Private equity firms and funds · Limited partnership · Limited liability company · Carried interest · Publicly traded private equity · Private Investment in Public Equity (PIPE) Investors Institutional Investors · Pension funds · Insurance companies · Endowments · Investment Banks · Commercial Banks · Fund of funds · High net worth individuals · Family offices · Sovereign wealth funds Related financial terms Undercapitalization · Initial Public Offering (IPO) · Mergers and acquisitions · Leverage · High-yield debt · Capital structure Private equity and venture capital investors · Private equity firms · Venture capital firms · Portfolio companies