Imagine making a fortune just by managing investments and selling them at the right time! That’s the world of private equity, where some of the richest people work. But there’s a hidden trick that helps private equity executives amass big money, and it’s called “carried interest.”

What is Carried Interest?

Carried interest, also known as “carry,” is the special reward private equity fund managers get when they sell investments at a profit. It’s like a bonus for doing a good job, and it’s not small – often, it can make people millionaires. But there’s a twist: unlike a regular salary, carry is usually taxed at a lower rate because it’s treated like a long-term investment gain, not regular income.

This tax benefit has caused a lot of debate. Some think it’s fair because private equity managers are risking their money alongside outside investors, but critics argue that it’s not fair since only a small part of the fund is their own money. Let’s dive deeper into why carried interest exists, how it works, and why it’s such a hot topic in finance.

The Billionaire Factory

Oxford University professor Ludovic Phalippou famously called private equity a “billionaire factory.” Why? Because in a matter of years, many executives have built enormous personal wealth through carry.

Private equity companies, like Blackstone or KKR, buy companies using borrowed money and later sell them for big profits. The carry is the part of those profits that goes straight to the private equity executives. While most companies pay salaries using management fees (a steady percentage of the total fund), the real wealth comes from carry, especially in times when borrowing is cheap and the returns are high.

A study from Oxford University revealed that since the year 2000, private equity firms globally have earned over $1 trillion in carried interest. Blackstone Group, the biggest private equity firm, alone has made more than $33 billion in carry.

Carried Interest Around the World

Carry might seem like just another reward, but it’s a big deal when it comes to taxes. In the United Kingdom, private equity executives received an average of £1.7 million each in carry during the 2022 tax year. Since carry is treated as a capital gain (meaning it’s taxed lower than regular income), these managers end up paying less tax on it.

Let’s take a look at tax rates in different countries:

UK: 28%
Spain: 22.8%
US (New York): 34.7%
Germany: 28.5%
France: 34%
Italy: 26%

In most places, the tax on carried interest is lower than what people pay on their regular salaries. That’s why so many people, including some famous financiers, are calling for change. They argue that carry should be taxed as regular income since private equity managers aren’t putting much of their own money at risk. In fact, on average, only about 4% of private equity funds come from the managers themselves, with the rest provided by outside investors.

Why Some Say Carried Interest is a Performance Fee

A lot of the criticism around carry centers on how little risk the managers take with their own money. In many cases, managers only put in 2-4% of the total funds. Critics say this makes carry more like a “performance fee” – a reward for doing well with other people’s money. They believe carry should be taxed like regular income since it’s mainly a reward for good results, not a return on personal investment.

Proponents of carried interest disagree, saying managers deserve this tax benefit because they’re making a long-term commitment and investing alongside their clients. This debate has kept carried interest in the political spotlight for years. In the U.S. and the European Union, there have been many discussions about changing these tax rules, and in the UK, the newly elected Labour government is currently reviewing them.

How Carried Interest Works

The structure of carried interest can vary from one private equity firm to another, but here’s how it generally works. Private equity companies set up large funds to invest in businesses. They buy companies, improve their performance, and then sell them after a few years for a big profit. If these investments go well, private equity managers get a share of these gains.

In most cases, carried interest represents about 20% of the fund’s profits, as long as the profits exceed a certain minimum. This minimum return ensures that investors get a reasonable benefit before the managers get their share. A return of over 20% per year is often the goal for private equity funds, which is why these managers earn such large amounts.

The Politics of Carried Interest

The topic of carried interest has become a political issue in many countries. Some leaders argue that private equity managers shouldn’t get tax breaks on carry, while others believe the tax benefit helps attract top talent to manage big funds. In the U.S., attempts to raise taxes on carried interest have appeared in multiple election campaigns, with politicians promising to make changes.

The debate is often about fairness. Opponents say it’s unfair that wealthy executives get tax breaks on carry, while ordinary people pay full taxes on their regular salaries. On the other hand, supporters argue that this tax treatment encourages investment and entrepreneurship, which can help the economy grow.

The Future of Carried Interest

What will happen to carried interest in the future? It’s hard to say. In the UK, the Labour government is reviewing the tax benefits for private equity, and there could be changes soon. Any major change in tax policy could influence how private equity operates worldwide.

For now, carried interest remains one of the most controversial perks in finance. The debate over carry is far from over, as people continue to question whether it should be treated as capital gains or as income. Whether you view carried interest as a fair reward or an unfair tax break, one thing is clear: it has helped create incredible wealth for those working in private equity.