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What is carried interest? (And why do you want it?)

If you’re reading up on or about private equity, you’ll almost definitely comes across the topic of “carried interest”. But what is it?

Long story short, it’s someone’s allocation of profit in a successfully executed private equity deal.

Long story long, private equity firms enter into deals (buying, for instance, a company) and after some time tinkering with them, sell them on (for a profit, if they’re any good at what they do). This is called “exiting” a deal.

A firm aims to exit an investment with at least a certain amount of profit, called a hurdle rate. This sum of money, which is usually a margin of 7-8%, goes to the “limited partners”. These are the third-party investors into a particular deal, and therefore those who have staked it financially.

Above the hurdle rate, things start getting interesting, and we introduce the “general partner”. The PE fund itself is the general partner – so “general partner” and “private equity fund” are interchangeable when looking at profit distribution.

Once the hurdle rate is cleared, the fund itself gets a share of the profits from a deal – and this sum, which is distributed to the various members that worked on a deal (as well as to the fund itself), is what constitutes the carried interest. ✨✨✨

The numbers can be astronomical at the upper end. A super-fund, which has tens of billions of dollars in AUM, enters and exits deals worth billions of dollars, and therefore distributes hundreds of millions to the participants in a deal.

Executive search firm Heidrick & Struggles noted that an individual private equity partner in Europe can earn around €25m in carried interest on a deal, once every five years. That’s colossal, and more than most bankers are paid, at any bank.

Another benefit of carried interest is that it’s treated as a capital gain, as opposed to a form of income. Which means that in the UK, it has a top tax rate of 28% - although potentially even lower via some tax loopholes – compared to a top income tax rate of 45%.

In the United States, where carried interest is also treated as capital gains, private equity professionals pay only 20% in tax on their gains – the top rate for capital gains – compared to the top band income tax rate of 37%.

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AUTHORZeno Toulon

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