Private Equity industry – what does compensation look like: Carried Interest

Carried interest, often referred to as “carry,” is a critical component of compensation in the private equity (PE) industry. It aligns the interests of fund managers with those of the investors, incentivising the creation of value.

Carried interest represents the share of profits that PE managers receive as compensation for successfully managing and exiting investments. Unlike management fees, which are fixed and based on the amount of capital under management, carried interest is performance-based, typically constituting around 20% of the profits generated by the fund. Based on the results of the 2023 MMK-Holt Private Equity and Venture Capital European Compensation Survey, 20% remains an industry standard.

Historically, carried interest was predominantly reserved for senior-level investment professionals who played a direct role in generating and executing deals. However, the landscape is changing as firms recognize the value brought by junior investment professionals and non-investment staff. According to the 2023 MM&K Survey, 60% of respondents indicated that their firms now offer carried interest to non-investment professionals. This evolution reflects a broader recognition of the diverse contributions required to achieve the firm’s investment objectives. As this trend continues, it will likely lead to more innovative and dynamic PE firms, better equipped to achieve sustainable success in a competitive industry.

The typical calculation of carried interest is predicated on achieving a hurdle rate, also known as a preferred return. This is the minimum return that limited partners (LPs) must receive before the PE managers, or general partners (GPs), can earn carried interest. The typical hurdle rate ranges from 6% to 8%.

One of the most contentious issues surrounding carried interest is its tax treatment. In many jurisdictions, carried interest is taxed as a capital gain rather than ordinary income, resulting in a significantly lower tax rate. In the UK, carried interest is generally subject to capital gains tax (CGT) at 28% rather than income tax, provided certain conditions are met. This distinction is crucial as CGT rates are typically lower than income tax rates, offering significant tax advantages to those receiving carried interest.

Carried interest remains a fundamental yet controversial aspect of the private equity industry. While it serves as a powerful incentive for fund managers to deliver exceptional returns, its preferential tax treatment continues to spark debate. As the landscape of private equity evolves, so too will the discussions surrounding carried interest, balancing the need to reward performance with considerations of tax fairness and equity.

For more insights into the 2023 MMK-Holt Private Equity and Venture Capital European Compensation Report, to participate in the 2024 Survey, or obtain advice on the structure of carry and its role in total compensation policy, please click here or contact Margarita Skripina.

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