Private equity and hedge funds are private investment vehicles that pools investment capital. The investment capital is generally pooled from wealthy individual investors or groups of institutional investors.
In particular, private equity firms acquire ownership stakes from other companies, improve their operations, restructure financial affairs, and seek to gain profit by selling after the hold period. On the other hand, hedge funds invest in any market where there is a profit opportunity and follow many strategies. The fund managers are the general partners whereas the outside investors are called limited partners.
They engage in financial activities that are forbidden for regulated companies. They choose the structure as per the individual circumstances of the investors. The US hedge funds and US private equity firms are generally structured as a limited partnership, as there is no entity-level tax on partnership or other flow-through entities as per the US tax system. As mentioned, the institutional and individual investors are the limited partners whereas the manager of the fund is referred to as a general partner.
As per the good old saying, ‘the rich get richer’, these private equity investment professionals and hedge fund professionals make tons of money every year and enjoy generous tax advantages at the same time. The carried interest provision allows the fund profits to get taxed as per capital gain and not a normal income. Moreover, the limited partnership structure –
- prevents double-taxation,
- limits partner liability,
- facilitates special-purpose vehicle establishment
The private equity industry and hedge funds possess a favorable regulatory treatment in jurisdictions and henceforth can take advantage of applicable rules to minimize the tax burden on the investors and fund managers. The growing influence of both sectors has put the tax rules under scrutiny by legislative bodies.
Let’s understand more about this carried interest here.
It is nothing but the share of the private equity or fund’s profits which serve as compensation for fund managers. The interest is issued only if the fund performs to an expected level or above it. In case, the fund fails to perform as planned, it cuts into the carried interest, and therefore the manager’s compensation. As it is a return on investment, the tax is calculated for capital gains and not for the income rate. This incentivizes the company’s management and profitability to funds.
The tax rate tends to be lower than the self-employment tax or income tax. The typical carried interest amount is about 20 percent for private equity and hedge funds as well. The PR funds charging carried interest include Bain Capital and Carlyle Group and they charge as high as 30 percent.
The carried interest of the general partners’ compensation gets vested for years and is received as earned. Typically, they are compensated with 2 percent of the fund’s assets. The industry maintains this fair compensation arrangement as they invest time and resources toward building profitability for their portfolio companies. They spend their valuable time for –
- Developing strategy
- Improving management performance
- Improving company efficiencies
- Maximizing the company’s value
- Preparing the portfolio company for sale or IPO (Initial Public Offering)
Having said all this, it is to be noted that the Tax Cuts and Jobs Act legislation, 2018 has changed the treatment of carried interest. According to the new law, a 3-year holding period for realized gains is required for the general partner to receive the long-term capital gain treatment. This has influenced the hedge fund managers more and might have to convert a part of the general partner interest to a limited partner interest, or make the general partner withdraw securities in-kind, or sell the securities, or distribute the securities to the owners of the general partners and sell them after.
The bottom lines
Carried interest is an incentive for the general partner for the contribution they do and earning good profits. It can be earned only if the profits exceed the hurdle rate.