Carried interest ("carry") is the share of a private fund's profits allocated to the general partner as performance compensation, separate from the management fee. The size of the share, and the conditions for earning it, such as first returning limited partners' contributed capital and a preferred return, are set in each fund's partnership agreement.
Why It Matters
Carry ties the manager's pay to the profits the fund earns for its investors, so how it is calculated, when it is paid and whether it can be clawed back decide what limited partners keep. The ILPA Principles, the Institutional Limited Partners Association's best-practice guidance for limited and general partners (guidance, not a rule), give its calculation, the waterfall and the clawback sections of their own.
How It Works in Practice
- 1The fund's distribution waterfall sets the order of payment. ILPA Principles 3.0 call a whole-of-fund model, in which all contributions plus the preferred return go back to limited partners before the general partner takes carry, best practice.
- 2In a deal-by-deal waterfall, carry can be paid as individual investments are realized. For such models, ILPA recommends that distributions return all realized cost for an investment and all fees and expenses to date, that unrealized investments be valued at the lower of cost or market, and that accrued carry be held in escrow against potential clawback.
- 3ILPA recommends calculating carry on net profits, after fund-level expenses, and favors a "hard hurdle", under which the general partner's carry is based only on the profits that exceed the limited partners' preferred return.
- 4In the United States, section 1061 of the Internal Revenue Code, added in December 2017 (Pub. L. 115-97), applies to an "applicable partnership interest", one held in connection with the performance of substantial services in an applicable trade or business. It treats the part of the long-term capital gain on such interests that does not meet the section's longer holding-period requirement as short-term capital gain.
Common Pitfalls
Assuming a standard rate. The carry share, the preferred return and any catch-up are negotiated terms of each fund's agreement, so two funds' carry can differ even when their headline terms look alike.
Paying deal-by-deal carry without protection. If carry is paid on early exits and later investments lose money, the general partner may owe carry back; ILPA recommends that clawback liabilities be disclosed every reporting period, that the clawback period extend beyond the fund's term, and that repayment be backed by joint and several liability of individual GP members or a creditworthy guarantee.
Treating the U.S. tax treatment as uniform. Section 1061 applies to applicable partnership interests and contains exceptions, so the treatment of a given carry allocation depends on the interest and the assets sold. This entry is not tax advice.
Sources
- ILPA Principles 3.0: Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners (2019) — Institutional Limited Partners Association
- 26 U.S. Code § 1061, Partnership interests held in connection with performance of services — Legal Information Institute, Cornell Law School
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