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Carried interest, also known as "carry," is a share of the profits earned by a venture capital (VC) fund's general partner (GP) as a result of successful investments. In other words, carried interest is a form of incentive compensation that rewards the GP for their contribution to the fund's performance.
Typically, the GP of a VC fund receives a management fee, which is a percentage of the assets under management (e.g., 2%), to cover their operating expenses. However, the carried interest is only paid out if the fund generates profits that exceed a certain threshold, known as the hurdle rate. The hurdle rate is usually set at a level that ensures that the GP only receives carried interest if the fund's investments perform well.
Once the hurdle rate is met, the GP is entitled to a percentage of the fund's profits, typically around 20%. This percentage can vary depending on the fund's structure and the negotiation between the limited partners (LPs) and the GP. The carried interest is paid out at the end of the fund's life cycle when the investments are sold, and the profits are distributed to the LPs and the GP. The carry percentage of 20% and the management fee of 2% would lead one to describe this fund as a 2 and 20 (2% management fee and 20% carry or profit interest).
Carried interest is a crucial component of the VC industry, as it aligns the GP's interests with those of the LPs, incentivizing them to make sound investment decisions and generate high returns. It also enables the GP to earn significant compensation if they successfully invest in companies that grow and generate substantial returns.
As a result of the 2017 Tax Cuts and Jobs Act (“TCJA”), investment funds must hold a carried interest for more than three years to be able to treat the gains from a carried interest as a long-term capital gain. This most certainly extends the previous holding period which was to hold the “carry” for more than one year, but most VCs and private equity (“PE”) firms hold their assets for more than three years, so this change should not be of material concern.
Information contained in this alert is for the general education and knowledge of our readers. Yellow Bear Capital, LLC does not provide legal or tax advice.
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