Mastering About Carried Interest

BONUS! Don’t you love that word

Getting paid for your work is normal but the feeling of being rewarded for your performance is unmatchable. In any profession, extra incentive linked to performance serves a greater purpose. It motivates you to work harder and achieve the milestones for every stakeholder involved. ‘Bonus’ in a layman's language can be called by different names in other lines of service.

Alternative investments are different from your traditional investments like stocks or gold. It goes a step higher with risk and returns. Investing in private equity, venture capital, hedge funds real estate, and commodities are alternative investment options. Incentives or profit-sharing for partners in the world of alternative investment is known as the carried interest. This article details what is a carried interest.

What is a carried interest?

A shares of the profit earned by the general partners of firms like private equity, venture capital, and hedge funds is known as the carried interest. Also known as ‘carry’, it is paid to the general partners upon hitting a minimum threshold return called the hurdle rate. General partners are the authorized personnel to execute business operations without the knowledge or consent of the other partners.

Carried interest is the additional compensation provided to general partners based on their performance rather than an initial investment in the fund. It is usually 20% of the profits above the pre-defined hurdle rate.

It is a common practice in private equity funds, hedge funds, and venture capitalist funds. In most countries, carried interest is treated as a long-term capital gain instead of an ordinary income, thus providing tax benefits. Typically, carried interest is distributed after a certain period and defers taxes in the form of unrealized capital gain.

It is noteworthy that a general partner receives the carried interest irrespective of whether they invest anything from their pockets towards the purchase of the fund constituents. Carried interest is named so as the partners eligible for the profit share in private equity funds or hedge funds are allowed to reinvest the funds and carry it over the years until they cash out.

How does carried interest work?

Before delving into how carried interest works, let’s highlight how private equity funds or hedge funds operate. Typically, private equities and hedge funds are structured as partnerships with a few external investors, known as the limited partners. The private equity firms in charge of operating the business and managing several funds are called the general partners.

Usually, general managers or fund managers charge both a management fee and an incentive fee. The management fee is like a salary that general managers take home, usually between 1% to 3% of the committed capital or the asset under management, irrespective of the fund performance.

An incentive fee, called the carried interest earned by the general partners after achieving the pre-determined rate of return, is called the hurdle rate. This carried interest usually amounts to 20% of a fund’s return. The limited partners receive 80% of the total profits of the equity fund along with the return of their initial investment (up till the hurdle rate).

There are instances where the general partners receive more than 20% of the total profit if it is distributed based on profits earned over time instead upon exiting the investment of the fund. To secure limited partners from this contingency, agreements and policies prohibit general partners from receiving the carried interest until the limited partners have received their capital back. An escrow account is set up for a portion of the carried interest and includes a clawback provision that forfeits the amount from general partners if the limited partners fail to receive their initial capital and 80% of the total profits.

Key restrictions of the carried interest

Carried interest is a vital concept for the fund managers operating alternative investments. While the general partners receive a carried interest, to ensure equality for the limited partners and other stakeholders involved, partnership and trust agreements put some restrictions on the release of a carried interest. Some of the forms of these restrictions are:

1. Hurdle rate:

   This is the minimum threshold return fund managers need to achieve to be eligible to receive a carried interest. The types of hurdle rates include:
   • Hard hurdle rate – Carried interest calculated on the amount above the hurdle rate.
   • Soft hurdle rate – Carried interest calculated on the whole profit amount only after achieving the hurdle rate.

2. High water mark:

   This clause prohibits crediting a carried interest till it reaches the previous highest mark. A high water mark protects investors from paying twice if the fund goes up the hurdle rate, falls below it, and then up again.

3. Clawbacks:

   This restriction tries to keep the general partners on their toes as it threatens the already received carried interest. In situations where the fund enjoys huge returns and pays out a part of carried interest only to see the performance plunge, the general partners have to give back some of the already received carried interest.

Hurdle rates, high water marks, and clawback provisions are specified in the partnership agreement.

How does taxation of carried interest work?

Carried interest is not classified as general income tax instead if held for more than three years is treated as a long-term capital gain tax, usually 20%. However, this has been a controversial topic and is often criticized as a loophole that allows private equity managers to pay a lesser tax rate.

Considering the above criticism, the Customs, Excise & Service Tax Appellate Tribunal, Bengaluru, India held in July 2021 that the service taxes were applicable in expenses incurred by PE-VC funds even under the trust structure. This means they ought to pay 18% GST on the carry fees.

Example of carried interest calculations

Suppose ABC PE Fund is a private equity firm that has raised INR 250 million funds from investors and general partners. ABC charges a 2% management fee based on assets under management at year-end and a 20% incentive fee based on returns over an 8% hurdle rate. In its first year, ABC appreciated by 16%.

In this case, after the first year, the fund value is INR 290 million (INR 250 million x 0.16).

The general partners receive the management fee of INR 5.8 million (INR 290 million x 0.02) irrespective of the fund performance.

The hurdle amount is INR 20 million (INR 250 million x 0.08).

The incentive fee or the carried interest allocated to the general partner is INR 2.84 million [INR(290 – 250 –20 –5.8) million x 20%].

If you notice, gains after the management fee above the hard hurdle rate are divided among limited partners and general partners in a ratio of 80:20.

The total absolute profit is INR 40 million (INR 290-250 million).

The profit after the mandatory management fee is INR 34.2 million (INR 40 – 5.8 million).

This profit crosses the hurdle rate of 8% by an amount of INR 14.2 million which is distributed among the limited parties and the general partners in a ratio of 80:20. (INR 2.84 million = 20% of INR 14.2 million).

Typically, general managers reinvest their incentive fees to take advantage of tax for long-term capital gains.