Carried interest

Carried interest or carry, in finance, is a share of the profits of a successful partnership that is paid to the manager of a private equity fund or hedge fund as a form of compensation that is designed as an incentive to the manager to maximize performance of the investment fund. A manager's carried interest allocation is in addition to any investment that the manager may have in the private equity fund or hedge fund.

In private equity, in order to receive carried interest, the manager must first return all capital contributed by the investors and in certain cases the fund must also return a previously agreed upon rate of return (the "hurdle rate") to investors. Hedge funds often are able to pay carried interest annually The manager's carried interest allocation will vary depending upon the type of investment fund and the demand for the fund from investors. In private equity, the standard carried interest allocation historically has been 20% for funds making buyout and venture investments, although in recent years more firms [Notable examples of private equity firms with carried interest of 25% to 30% include Bain Capital and Providence Equity Partners.] Carried interest rates among hedge funds have historically also centered around 20%, but have had greater variability than private equity funds, occasionally reaching as high as 50% of a fund's profits.

Carried interest and management fees

Historically, carried interest has served as the primary source of income for the manager in both private equity and hedge funds. Both private equity firms and hedge funds tended to have a small annual management fee (1-2% of committed capital), the management fee is meant primarily to cover the costs of investing and managing the fund rather than for meaningful wealth creation for the manager.

As the sizes of both private equity and hedge funds have increased, management fees have become a more meaningful portion of the value proposition for fund managers as evidenced by the 2007 initial public offering of the Blackstone Group.

Taxation of carried interest

United States

Because the manager is compensated with a profits interest in the fund, the bulk of its income from the fund is taxed, not as compensation for services, but as a return on investment. Typically, when a partner receives a profits interest (commonly referred to as a "carried interest"), the partner is not taxed upon receipt, due to the difficulty of ascertaining the present value of an interest in future profits. [See, e.g., Campbell v. United States (8th Cir. 1981). This approach was adopted as a general administrative rule by the IRS in a notice in 1993, and again in proposed regulations in 2005.] Instead, the partner is taxed as the partnership earns income. In the case of a hedge fund, this means that the partner defers taxation on the income that the hedge fund earns, which is typically ordinary income (or possibly short-term capital gains), due to the nature of the investments most hedge funds make. Private equity funds, however, typically invest on a longer horizon, with the result thatincome earned by the funds is long-term capital gain, taxable to individuals at a maximum 15% rate. Because the 20% profits share typically is the bulk of the manager’s compensation, and because this compensation can reach, in the case of the most successful funds, enormous figures, concern has been raised, both in Congress and in the media, that managers are taking advantage of tax loopholes to receive what is effectively a salary without paying the ordinary 35% marginal income tax rates that an average person would have to pay on such income. To address this concern, Congressman Sander M. Levin introduced H.R. 2834, which would eliminate the ability of persons performing investment adviser or similar services to partnerships to receive capital gains tax treatment on their income. [http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_cong_bills&docid=f:h2834ih.txt.pdf] However, the Treasury Department has suggested, both in testimony before the Senate FinanceCommittee [ [http://finance.senate.gov/hearings/testimony/2007test/071107testes.pdf Microsoft Word - 07.11.07 TESTIMONY Solomon on Carried Interest.doc ] ] and in public speaking engagements, [ [http://www.bloomberg.com/apps/news?pid=newsarchive&sid=alm0Crt0eICY Bloomberg.com: News ] ] that altering the tax treatment of a single industry raises tax policy concerns, and that changing the way partnerships in general are taxed is something that should only be done after careful consideration of the potential impact.

Congressman Rangell included a revised version of H.R. 2834 as part of the "Mother of All Tax Reform" and the 2007 House extenders package. The provision passed the House and has been referred to the Senate, where it is unclear if a carried interest proposal could receive 60 or more votes.

United Kingdom

The Finance Act 1972 provided that gains on investments acquired by reason of rights or opportunities offered to individuals as directors or employees were, subject to various exceptions, taxed as income and not capital gains. This may strictly have applied to the carried interests of many venture capital executives, even if they were partners and not employees of the investing fund, because they were often directors of the investee companies. In 1987 the Inland Revenue and the British Venture Capital Association entered into an agreement which provided that in most circumstances gains on carried interest were not taxed as income.

The Finance Act 2003 widened the circumstances in which investment gains were treated as employment-related and therefore taxed as income. In 2003 the Inland Revenue and the BVCA entered into a new agreement which had the effect that, notwithstanding the new legislation, most carried interest gains continued to be taxed as capital gains and not as income. [ [http://www.hmrc.gov.uk/shareschemes/bvca_and_fb2003_carried_interest.pdf Memorandum of Understanding, 2003, Inland Revenue and BVCA] ] Such capital gains were generally taxed at 10%, as opposed to a 40% rate on income.

In 2007 the favourable tax rates on carried interest attracted political controversy. [ [http://news.bbc.co.uk/1/hi/business/6264466.stm BBC News, 3 July 2007] ] It was said that cleaners paid tax at a higher rate than the private equity executives whose offices they cleaned. [ [http://news.bbc.co.uk/1/hi/business/6743465.stm BBC News, 12 June 2007] ] The outcome was that the capital gains tax rules were reformed, increasing the rate on gains to 18%, but carried interest continued to be taxed as gains and not as income. [ [http://www.hmrc.gov.uk/pbr2007/pbrn17.pdf HMRC PBRN 17, 9 October 2007] ]

ee also

*Taxation of private equity and hedge funds
*Private equity
*Private equity firm
*Private equity fund
*Hedge fund

References