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%.
The rationale for the lower tax on the carry is that the general partner takes on risk similar to that of an entrepreneur when buying and selling portfolio companies. It’s not guaranteed that these companies will sell for a profit, so the lower tax is viewed as a reward for taking on the risk.
Critics of carried interest taxation seek reclassification of the capital treatment to ordinary income. Opponents suggest that if carried interest were taxed at the higher rate, it could positively impact the reduction of the U.S. budget deficit. Critics also argue that it is unfair that wage earners are forced to pay a higher tax on their salaries than general partners do on their management compensation.
The hedge and private equity fund industries have lobbied hard against changes to carried interest, arguing that carried interest aligns the interests of the general and limited partners. Proponents are concerned that if the tax incentive for the general partners is diminished, performance would suffer. Others argue that if the profits from carry decreased, then private equity firms might look for income in other ways, perhaps through an increase in the 2% management fee.
Proposed Legislation
A bill has been introduced in Congress related to taxation of carried interest: The Carried Interest Fairness Act of 2015 (H.R. 2889). Though it has not gained any traction, the bill seeks to amend the Internal Revenue Code to treat net capital gains related to partnership interests in investment service funds as ordinary income. Under the bill, transferred partnership interests in connection with the performance of services would be included currently in gross income.
What Investors Need To Know
Because private equity funds are alternative investment vehicles, they don’t receive as much regulation as publicly traded equities and mutual funds. Additionally, because much of the data behind private equity financials is kept private, there is not much transparency available to investors to verify the calculations and fees associated with their investments.
That means limited partners place a great deal of trust in the fund managers and their auditors. As a result, investors should be sure to perform their own due diligence. For instance, limited partners should thoroughly review partnership agreements and any other relevant paperwork. Investors should also verify that fund auditors are reputable and have experience auditing private equity funds. Investors should also keep in mind that private equity investments are generally higher risk, illiquid investments and, as such, they cannot be easily exited.
What investors should not do is use carried interest as the sole criteria for ruling out alternative investments, some of which are directed by some of the best minds in the financial industry. Many institutions and pensions have continued to put large sums in alternative vehicles and have performed well despite the fees. This in itself speaks to the success of these types of investments.
Adam Dauber, CPA, is a manager in the private client services group of CBIZ MHM LLC, a New York City-based accounting and business consulting company.
