I recently spoke with a reporter at a major newspaper who was doing a story on a private equity fund. He asked some fundamental questions on private equity, for example he asked about a private equity fund cycle (which I answered here.) Now, I’m going to provide a quick explanation of another aspect of private equity: carried interest. (There are more detailed videos available through the Private Equity Training program we offer).
What is Private Equity Carried Interest?
Definition: Carried interest is the percentage of profits that the general partners of a private equity fund receive as an incentive for good performance. The carried interest compensation typically ranges from 20-30% of profits which is a substantial amount of money for the fund’s investors. This may vary by the performance, experience and investor enthusiasm of a fund. If a fund is ran by a highly-reputable management team, has a great track record and investors are lining up to get in the fund, then they may charge a higher than 20%-average carry; conversely, a new fund or one that expects trouble in attracting investors may lower its fees and take a smaller percentage of the profits.
A private equity fund is a partnership created to obtain a significant (often majority) stake in an expanding or underperforming company. Outside investors, the limited partners, provide most of the funding capital typically 90-97%. The remaining funding of 3-10% is provided by the general partners of the fund who in turn receive management fees. The typical compensation set up for private equity fund managers is 1-2% of the total fund assets and the carried interest. This arrangement is often very beneficial for the manager and serves as a method for investors to motivate and reward good performance by the general partners.
In a private equity fund, the fees are taken exiting the investments and distributing capital to the investors, then the GP takes the carry and distributes that to the management team and a smaller cut to mid-level employees depending on their compensation structure. For many private equity professionals, the carry represents a substantial incentive and often a substantial bonus on their base pay.
The tax treatment of carried interest is a frequent source of controversy as it is taxed significantly lower than ordinary income. Private equity and hedge fund proponents of the current capital gains tax treatment argue that this lower tax rate is justified by the substantial risk that private equity and venture capital funds incur by investing in risky and sometimes distressed companies.