Carried Interest: Everything You Need to Know
Carried interest, also known as carry, is a share in the profits that general partners receive in compensation for the management of a venture capital fund.5 min read
What Is Carried Interest?
Carried interest, also known as carry, is a share in the profits that general partners receive in compensation for the management of a venture capital fund. These profits can be long-term gains, dividends, short-term gains, or interest and total 20 to 25 percent of the fund's profits. However, general partners aren't required to invest their own money. Instead, these funds are intended as motivation for a general partner that are only available at the sale of the fund.
The best way to picture carried interest is through an example. Imagine you give a friend $100 to put on roulette when they go to Vegas, and they win $200. If you agreed to a 20 percent cut for your friend, you'll pay $20 on the interest. This is how carried interest works.
Another way to visualize carried interest is through another example. Let's say Alan sets up a venture capital fund as a limited liability partnership. He appoints himself the general partner. This means he has to manage the fund and is responsible if the fund goes belly up. He then finds limited partners to invest. However, limited partners have no liability if the fund is unprofitable.
In this example, Alan would get a relative percentage based upon the money he put in, as would the limited partners. He would also receive compensation for managing the fund, which would be taxed as ordinary income. If he receives a larger percentage of the profits than the amount he put in, this is called carried interest. It would also come with a capital gains tax rate.
A typical venture capital fund contains 25 companies that pay off after four or five years. Carried interest is paid in addition to a quarterly management fee that acts as the partner's salary. This management fee usually only covers a general partner's expenses. It also totals about 2 percent of the value of fund assets. These two things make up the full pay for managing the fund.
General partners, also known as fund managers, are one-half of fund partnership along with limited partners. General partners have unlimited liability. However, they can also make decisions without the permission of limited partners. To earn carried interest, general partners:
- Find other investors
- Organize the fund
- Manage it
- Endure 100 percent of the risk
- Put up 0 percent to 10 percent of the capital.
- Forge a relationship with entrepreneurs and the businesses in their portfolio
- Develop strategy
- Maximize value of fund before sale or initial public offering of a company
Even with millions of dollars on the line and a timeframe of 5 years, only about 25 percent of venture capital funds are profitable. Even though profitability is low, some managers excel. Jim Simmons is the manager of Renaissance Technologies, which is valued at $65 billion. Because Simmons gets returns with an average of 71.8 percent, he gets management fees of 5 percent and carried interest of 44 percent.
Limited partners are the main investors, but do not manage the fund and share in the profits without an extra fee. Together, these two types of investors make up what's called a limited partnership. Carried interest is only paid to general partners after limited partners receive their original investment and profits. This profit or rate of return is also known as the hurdle rate. Some funds also have a floor. This is when general partners only get carry after meeting the hurdle rate.
Limited partners include:
- Wealthy individuals
- Pension funds
- Asset management companies
- Trust funds
One common mistake that people make is confusing carried interest with a consultation fee. However, consultants receive money for their time, take no risk, and don't have a fee linked to business success.
Why Is Carried Interest Important?
Carried interest is important for several reasons:
- It provides an incentive to managers for taking on huge risks
- It is taxed at a capital gains rate of between 15 percent and 20 percent
- It isn't given until limited partners are paid back their initial investment plus a rate of return
Another reason that carried interest is at the center of debates is because of how it's taxed. Because it's not classified as ordinary income, general partners have to pay far less tax than they normally would. This creates a controversy that carried interest is a tax loophole.
During the last presidential election, both Donald Trump and Hillary Clinton vowed to end carried interest. They see it as a tax loophole that benefits the rich. However, neither candidate gave a concrete way to close the loophole.
Reasons to Consider Using Carried Interest
Carried interest is figured differently depending on the fund. Deal by deal carry is beneficial for general partners. Normal agreements combine losses and gains to determine the bottom-line for profit sharing. However, deal by deal carry allows general partners to take the profits on only the winning assets. They do not have to factor in losses. Although limited partners must be paid back, a deal by deal carry is far more profitable for general partners.
Deal by deal carry is also bad for venture funds. This is because general partners tend to only pay attention to the winners in a portfolio and ignore the rest. This is already common in hedge and equity funds, but new to venture capital funds. Supporters cite that only a few winners exist in a fund, so it's not a terrible way to figure carry.
Carry is also figured by equity in the fund. Interest is based on limited partners' capital contribution. Twenty percent of this becomes allocated to carry.
Frequently Asked Questions
- Can you receive carried interest before the sale of the venture capital fund?
In most cases, general partners can take profits from early success in the fund. However, if the fund fails and becomes unprofitable, the partner must pay the money back. This is referred to as "claw back." Carry can also be put in escrow accounts until the sale of the fund.
- What amount of carried interest is usually paid to general partners?
Traditionally, carried interest totals 20 to 25 percent of the profits. This total is large compared to the management fee. It represents a majority of a general partner's income. Carried interest is also vested over the life of the fund to ensure constant fund management. Some venture capital managers also get compensation through the Two and Twenty principle. This states that they get a 2 percent management fee and 20 percent of profits.
- Is carried interest guaranteed?
Venture capital funds do not guarantee carried interest. Only the management fee is covered.
- How is carried interest taxed?
Carried interest is taxed on the capital gains rate. This is between 15 percent and 20 percent with a 3.8 percent investment tax. Supporters claim this is how most entrepreneurs are taxed and argue that it mitigates double taxation. Critics want the amount to be taxed as ordinary income and see the status quo as unfair. Despite several attempts to change the tax code, carried interest tax remains the same as its been for 50 years.
- Does anyone else receive carry?
Unfortunately, general partners don't keep all of their carried interest. It's divided among retired general partners, minority shareholders, or a parent company.
- How does carried interest work in other countries?
Europe has a whole-of-fund approach. This is where general partners only get carry after paying all investors. In Australia, general partners need a proven record to negotiate any carry terms.
- How does accounting apply to carried interest?
Generally accepted accounting principles provide options for carried interest accounting. Some use an accrual basis, while other opt for a cash basis or valuation techniques.
If you need help figuring out if carried interest is good for your business or have any legal questions, post your question on UpCounsel's marketplace. UpCounsel accepts only the top lawyers to its site with an average experience of 14 years in law practice.