What is carried interest? The carried interest definition
Carried interest is the share of an investment fund's profits that is used to pay the general partners (GPs) or portfolio managers. The carried interest can also be seen as the performance fees of the investment fund.
Most investment funds charge annual management fees that help the fund cover its operational expenses. The carried interest, on the other hand, acts as the primary source of income for portfolio managers. Because the better the fund performs, the higher the carry distributions, carried interest also acts as a tool to align the interests of the investors (limited partners, or LPs) and the portfolio managers (general partners, or GPs).
In practice, a typical private equity fund might charge a 2% annual management fee and 20% carried interest — often referred to as the "2 and 20" model.
How to calculate the carried interest? The carried interest calculator
To understand how to calculate carried interest, let's use Fund Alpha as an example with the following information:
- Initial fund value: $10,000,000
- Final fund value: $20,000,000
- Hold period: 5 years
- Hurdle rate: 5%
- Carried interest: 20%
The carried interest calculation follows 4 key steps:
Step 1: Calculate the fund return
The fund return measures the overall performance of the investment fund:
Fund Return = Final Fund Value / Initial Fund Value − 1
For Fund Alpha: $20,000,000 / $10,000,000 − 1 = 100%
Step 2: Determine the hurdle rate
The hurdle rate (also called preferred return or minimum acceptable return) is the minimum fund return that an investment fund must achieve before portfolio managers begin receiving carry distributions. For Fund Alpha, the hurdle rate is 5% per year.
Step 3: Determine the carried interest percentage
The carried interest percentage is the share of profits above the hurdle that the GPs receive as their performance fee. For Fund Alpha, this is 20%.
Step 4: Calculate the carry distribution
The carry distribution is calculated using the formula:
Carry Distribution = (Final Fund Value − Initial Fund Value × (1 + Hurdle Rate)Hold Period) × Carried Interest
For Fund Alpha:
Carry Distribution = ($20,000,000 − $10,000,000 × (1 + 5%)5) × 20%
= ($20,000,000 − $12,762,815.63) × 20%
= $7,237,184.37 × 20% = $1,447,436.87
If the carry distribution is negative, it means the investment fund performance is below the hurdle rate and the portfolio managers will not receive any carry distributions.
GP catch-up provision
For advanced calculations, you can also enable the GP catch-up option. Once the fund's return surpasses the hurdle rate, the GP catch-up provision allows the general partner to receive a greater share of the profits until they "catch up" to their target carry percentage of total fund profits (not just profits above the hurdle).
With the catch-up provision, the GP effectively receives their carried interest percentage applied to all profits (rather than only profits above the hurdle), resulting in a higher carry distribution.
What is the carried interest loophole?
The carried interest tax loophole (also known as the carried interest loophole) is a tax regulation that allows portfolio managers to treat the carry distributions they earn as capital gains rather than ordinary income.
This means that portfolio managers typically pay the capital gains tax rate on their carry distributions, which is usually significantly lower than the income tax rate. For example, in the United States, long-term capital gains are taxed at a maximum rate of 20%, compared to the top ordinary income tax rate of 37%.
This loophole has been a subject of ongoing political debate, with critics arguing that it unfairly benefits wealthy fund managers while proponents claim it aligns incentives and encourages long-term investment.
European method vs. American method
There are two primary approaches to distributing carried interest:
- European method (whole-fund): The GP receives a percentage of the profits only after the investors (LPs) have received their entire invested capital back plus the preferred return. This calculator uses the European method.
- American method (deal-by-deal): The GP receives carry on each profitable investment deal separately, even if other deals in the fund are unprofitable. This method is more favorable to the GP but riskier for investors.
Disclaimer
This calculator focuses on the European (whole-fund) carry allocation method. The actual carried interest calculation in practice may involve additional complexities such as clawback provisions, management fee offsets, tax distributions, and tiered carry structures. Always consult with a qualified financial or legal advisor for investment fund matters.