Carried interest, the share of profits that general partners of private equity and hedge funds may receive as compensation, is a controversial topic these days, but it actually originated more than 500 years ago.

In the 16th century, medieval shipping magnates would charge a 20% fee on all profits generated by the cargo they “carried.”

Today, many fund managers have used the same concept, with some racking up billions in compensation in the process.

That’s one of the reasons why carried interest is often the subject of political debate and public scrutiny. When advisors and their clients weigh the impact of carried interest on their potential investments, they should at least have a thorough understanding of how the concept works.

How It Works

Carried interest is most closely associated with private equity funds, which are made up of limited partners, general partners and the funds themselves. The general partners consist of the direct managers, traders and analysts that manage the fund’s investments. The limited partners are the investors who contractually commit capital to the fund. 

Most private equity firms operate under the 2/20 fee structure. Essentially, regardless of fund performance, the general partner will charge a 2% fee on all capital deployed by the limited partners. This fee is strictly for overhead and “keeping the lights on.” If the fund performs well, or above the “hurdle rate”—the target for fund performance is typically set between 6% and 8%—the general partner will assess a 20% incentive fee on fund profits. 

For example, if a fund manager generates returns of 15% one year and the fund hurdle rate, or “preferred return,” is 8%, the remaining 7% will be subject to carry. With a 2/20 fee structure, the private equity firm would keep 20% of the 7% portion of assets above hurdle, or about 1.4% of invested assets. When funds hold billions of assets, this leads to substantial sums going into the pockets of managers, which is why carried interest has been so controversial in recent years.

Additionally, it’s important to note that there is often a catch-up period where, after limited partners receive their preferred return, the general partner receives most or all of the profits until the carried interest allocation has been reached.

While the calculation seems simple, studies show that investors usually do not verify whether the carried interest assessment has been computed correctly. Carried interest payments are deducted from the distributions before the investors receive them. Therefore, in order to calculate it, investors would need to obtain information such as IRR (the internal rate of return), portfolio valuations, etc., for each fund every quarter. Moreover, some funds may hold hundreds of investments, and fund managers are not always willing to provide the data for all of them. As a result, investors generally rely on fund managers and fund auditors to verify the accuracy of the carried interest calculation. 

How It Is Taxed

The taxation of carried interest has been the focal point of contentious political debates through the years. 

The management fee received by private equity firms—usually 2%—is taxed as ordinary income and subject to the top federal rate of 39.6%

Carried interest fees, on the other hand, are taxed as a long-term capital gain, a much more favorable tax rate when compared with ordinary income. Currently, the long-term capital gains rate is 20% plus 3.8% on investment income, amounting to a tax rate of 23.8%.