Key Insights
- Carried interest provides compensation to the general partner and/or manager of an investment, based on the investment’s performance.
- Paying carried interest reduces the return to individual investors. However, without the general partner/manager, the investment may have performed much worse, or may not have been available at all.
- There is some disagreement about whether carried interest should be taxed as earned income or capital gains. It is currently taxed as capital gains.
Carried interest is a driving factor behind some of the most profitable investment types available. But many investors aren’t completely clear on the concept of carried interest.
This article will answer common investor questions about carried interest, including:
- What is carried interest?
- How does carried interest work?
- How does carried interest affect investors?
Carried Interest Definition
Carried interest is compensation paid to the general partner (GP) or manager of an investment funded by a group of investors. This payment is based on the performance of the investment, usually as a share of the profits.
The GP/manager is typically responsible for creating the LLC or trust that owns the investment asset(s), as well as managing the direction of the investment, so their involvement can dramatically impact the profitability of an investment. Tying their compensation for this service to the success of the investment incentivizes the GP/manager to optimize the return on investment (ROI).
Investment types that may pay carried interest to GPs include the following:
- Private equity
- Joint ventures
- Hedge funds
- Crowdfunding
- Real estate syndication
How Carried Interest Works
To understand how carried interest works, we need to look at the beginning of the relationships between a group of investors.
When multiple investors combine capital to fund an investment, an LLC or trust is typically created to serve as the ownership entity of the asset.
For example, a real estate syndication company may create an LLC to acquire a new property. The syndication company (often called the real estate sponsor) would be listed as the GP, and individual investors would be listed as Limited Partners (LPs). LPs hold equity in the project and are entitled to a share in the profits. However, the GP is responsible for guiding the investment, so the GP is entitled to compensation for a job well done when the investment performs well for the investors. The carried interest serves as this compensation and is paid as a percentage of the profits.
In some cases, an investment may come with a hurdle rate. A hurdle rate, in this context, is the minimum expected rate of return for the project to be considered a success. If an investment has a hurdle rate, the GP is only entitled to its carried interest if the investment performs better than the hurdle rate.
For example, if an investment has a hurdle rate of 5% and results in a 4% return, the hurdle has not been cleared, and the GP is not entitled to carried interest. However, if an investment has a hurdle rate of 5% and results in a 6% return, the GP is entitled to its carried interest compensation.
How Carried Interest is Calculated
Carried interest is calculated as a percentage of the profits. While the percentage varies by investment type (and even from one investment project to the next), 20% is a common rate of carried interest.
If a project has a hurdle rate, the carried interest percentage is applied to the entire profit (not just the gains over the hurdle rate).
The formula for calculating carried interest is:
Carried interest = profit x carried interest rate.
Example of a Carried Interest Calculation
Let’s assume you invest in a real estate syndication opportunity with a hurdle rate of 4% and a carried interest rate of 15%. The profit of the project (the total investment value minus the initial investment) is $300,000, representing a return of 10%.
In this scenario, the hurdle rate of 4% has been cleared with an impressive 10% return. So the GP is awarded its 15% carried interest rate on the profit as follows:
$300,000 profit x 15% carried interest rate = $45,000 in carried interest
The remaining $255,000 profit would then be distributed among the investors (the LPs in the deal).
How Carried Interest is Taxed
As of 2024, carried interest is considered investment income by the IRS, so it is taxed as capital gains, rather than earned income. This benefits the GP/manager because capital gains are taxed at a lower rate than earned income.
There is some discord about this system of taxation. Proponents argue that the GP/manager’s role is comparable to "sweat equity" in a business investment, which qualified carried interest as capital gains. Opponents argue that carried interest is how many individuals in the GP role make a living, so it should be taxed at earning income rates.
In an effort to ensure fair taxation, the 2017 Tax Cuts and Jobs Act increased the minimum holding period from one year to three years for carried interest income to qualify as long-term capital gains (most investments must be held for just one year to qualify as capital gains). Some Americans are satisfied with this change. Others feel that the minimum hold period should be even longer since many projects that award carried interest are five years or longer.
How Carried Interest Affects Investors
Carried interest payments to the GP come from the investment’s profits, so they reduce the amount to be split among the investors. However, in most cases, the project would not perform as well (or even be available) without the GP. So investors are typically comfortable paying performance-based carried interest compensation to the GP in exchange for creating the opportunity and successfully managing the project.
Carried Interest FAQs
Why is it called carried interest?
The term carried interest dates back to the 16th century when shipping captains were entitled to 20% of the profits made from the sale of the goods carried on their ships. This “carried interest” was the captain’s reward for assuming the risk of transporting goods across the ocean and successfully delivering the goods to the port.
Why is there a controversy around carried interest?
There is some controversy around carried interest being taxed at lower capital gains rates. Some legislators feel that carried interest should be taxed at the higher earned income tax rates because GPs often make their living from carried interest. However, the current system taxes carried interest as capital gains because the GP’s involvement in the deal is essentially sweat equity in a business investment.
What is a carried interest clawback?
A carried interest clawback is when LPs of an underperforming investment invoke a clause in their agreement with the GP to reclaim some of the carried interest that was awarded to the GP. For example, let’s say a GP sold investors on the idea of 10% returns, but the investment only returned 5%. If the LLC or partnership agreement allows for a clawback, LPs may be able to recover some of the money paid to the GP in carried interest.
Make Carried Interest Work for You as an Individual Investor
Very few individual investors ever become general partners in a complex investment project. But that doesn’t mean you can’t benefit from carried interest.
By investing in deals that pay carried interest to the GP, you can increase your return potential. This is because carried interest payments incentivize GPs to maximize the profitability of the investment. The more profitable the investment is, the more money the GP makes. And, the more profitable the investment is, the more money you make as an investor!
Plus, as an investor in a deal with a GP/manager, your returns are completely passive. You don’t have to scout hundreds of potential opportunities to find the gems with the best potential or stress over the day-to-day management of the asset. The GP will do all of that for you. Not only does this allow you to spend your time on other ventures, but it also allows investors with zero experience to profit from complicated deals.
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