Carried Interest, often referred to as “carry,” is a share of the profits earned by investment fund managers, typically in private equity, venture capital, or hedge funds, as compensation for successfully managing the fund and generating returns for investors. Carried interest serves as a performance incentive, aligning the interests of the fund managers with those of the investors. It is usually structured as a percentage of the fund’s profits and is only paid if the fund achieves a certain level of profitability.

Key Aspects of Carried Interest:

1. Structure of Carried Interest:
   • Percentage of Profits: Carried interest is typically set at a fixed percentage of the profits generated by the fund. Commonly, this percentage is 20%, but it can vary depending on the specific terms of the fund. For example, if a fund earns $100 million in profits, the fund managers would receive $20 million as carried interest.
   • Hurdle Rate: Many funds include a hurdle rate, or preferred return, which is the minimum rate of return that the fund must achieve before the managers are entitled to receive carried interest. This ensures that investors receive a certain level of return before the managers are compensated.
   • Waterfall Structure: The distribution of profits in a fund typically follows a “waterfall” structure. This means that profits are distributed to investors first to cover their initial investment and any preferred return, and only after these obligations are met does the carried interest become payable to the fund managers.
2. Purpose and Incentives:
   • Aligning Interests: Carried interest is designed to align the interests of fund managers with those of the investors. By tying a portion of the managers’ compensation to the fund’s performance, managers are incentivized to maximize returns for the investors.
   • Performance-Based Compensation: Unlike management fees, which are typically a fixed percentage of the fund’s assets under management (AUM), carried interest is directly tied to the success of the investments. This performance-based compensation encourages managers to take calculated risks and make decisions that will enhance the fund’s profitability.
3. Tax Treatment:
   • Capital Gains: In many jurisdictions, carried interest is treated as a capital gain rather than ordinary income, which often results in a lower tax rate. This favorable tax treatment has been a subject of debate and controversy, as some argue that it gives fund managers an unfair tax advantage.
   • Tax Reform Proposals: There have been ongoing discussions and legislative proposals in various countries, particularly in the United States, to change the tax treatment of carried interest, potentially taxing it as ordinary income, which could lead to higher tax rates for fund managers.
4. Examples of Carried Interest in Practice:
   • Private Equity Funds: In a private equity fund, the fund managers might invest in companies, improve their operations, and eventually sell them at a profit. If the fund achieves returns above the hurdle rate, the managers receive carried interest based on the profits generated from these investments.
   • Venture Capital Funds: In a venture capital fund, managers invest in early-stage companies with high growth potential. If these companies are successfully exited through IPOs or acquisitions, the managers earn carried interest from the profits made on these exits.
5. Criticism and Controversy:
   • Income Inequality: Critics argue that the tax treatment of carried interest contributes to income inequality by allowing wealthy fund managers to pay lower tax rates on significant portions of their income.
   • Risk and Reward: Some critics also contend that carried interest provides fund managers with substantial rewards without sufficient risk, as they often receive management fees regardless of the fund’s performance. However, proponents argue that carried interest compensates managers for the risks they take in pursuing high-return investments.
6. Legal and Regulatory Considerations:
   • Jurisdictional Differences: The treatment of carried interest varies by country, with different tax laws and regulations affecting how it is classified and taxed. Fund managers need to navigate these legal frameworks carefully to optimize their compensation and compliance.
   • Disclosure Requirements: In some regions, fund managers are required to disclose their carried interest arrangements to investors, providing transparency about how they are compensated and how profits are distributed.
7. Evolution and Trends:
   • Changing Structures: As the investment landscape evolves, some funds have adjusted the structure of carried interest, introducing tiered carry arrangements where the percentage of carried interest increases with higher levels of fund performance.
   • Impact of Market Conditions: Market conditions can influence the amount and likelihood of earning carried interest. In periods of economic downturn or poor investment performance, fund managers may receive little or no carried interest, depending on the fund’s profitability.

In summary, Carried Interest is a share of the profits earned by investment fund managers as a form of performance-based compensation. It is intended to align the interests of managers and investors by incentivizing managers to generate strong returns. Carried interest is often treated favorably for tax purposes, leading to ongoing debates about its fairness and impact. Despite the controversy, it remains a common and influential component of compensation in the private equity, venture capital, and hedge fund industries.