March 30 2012
by Todd Hixon

An Insider Perspective On Carried Interest

Public dissection of Mitt Romney’s tax returns has put “carried interest” in the spotlight, but many people don’t know what carried interest is or why it’s there. A segment on the Marketplace radio program last week (link) brought this home for me. [IMHO, Marketplace is about the best business program on the radio.] I was troubled by Nancy Marshall Genzer’s piece that boiled down to 1) carried interest is a kind of consulting fee that private equity managers receive and 2) it should be highly taxed because rich private equity managers like Mitt Romney receive most of it. I will leave the question of tax policy alone: I’m not good at politics. But I’d like to correct the facts in this story

There were two bloopers. First Ms. Genzer used the song “The Little Old Lady From Pasadena in her report and attributed it to The Beach Boys. This got a lot of listener comments and an immediate correction, giving due credit to Jan and Dean.

Definitely Not A Consultant (Tim Draper, Well-Known Venture Capitalist). Photo via

The bigger error: carried interest is profoundly different from a consulting fee. I’m going to describe carried interest from the perspective of a venture investor, which is what I do. Venture capitalists have been using the carried interest concept since the modern VC industry arose in the 1960s. Private equity and hedge funds adopted the idea later.

Most venture investing occurs via a partnership, a legal vehicle through which people do business together and share the economics. If my brother and I run a lemonade stand and share everything equally, that’s a partnership. In a VC partnership, a group of investors (many of them are pension funds, endowments, etc.) come together and create a pool of capital (i.e., money). The capital is invested in about 25 start-up companies over 4-5 years. These investments take 5-10 years to pay off. The partners receive a share of the proceeds when the start-ups are sold or turn into publicly traded companies (called “liquidity events”). When all of the companies are gone, the partnership winds up.

Venture investors use a sophisticated form of partnership called a “limited partnership” in which there are two kinds of partners: limited partners and general partners. The limited partners provide most of the money, but they take no role in management and they can’t be sued for the debts of the partnership. The general partners (“GPs”) find the investors and organize the partnership, they put up the remaining 1%-10% of the capital, they manage the business (usually a full time job), and they can be sued. This makes sense: some partners want to be passive investors, and some want to be active managers.

For managing the partnership and taking risk, the General Partners receive compensation: a quarterly “management fee” and a profit share that is larger than the share of the capital they contribute. This extra share of profits is the “carried interest”, a name only a lawyer could love. The management fee is paid quarterly; it covers operating expenses and provides the GPs a salary that is usually about 1/3 of what the GPs hope to receive. The carried interest is paid when companies become liquid, only after the limited partners have been paid back all of their investment.

Here is my point. Consultants have a very different deal (I know because I was one for a long time). They get paid for their time, immediately, and they take little risk: their fee is not linked to business success.

Carried interest is a profit share: it is 100% at-risk depending on performance, and it is paid only when companies are sold or go public, which typically occurs 5-10 years from the start of the partnership. If the GPs take profit from early successes and then later failures erode profitability, they have to pay money back when the partnership winds up [this is called “claw back”, if only it worked this way on Wall Street …]. And carried interest is a share of each kind of profit: it can be long-term gain, dividends, short-term gain, or interest (the last two are taxed the same way as wage income). However, since VC partnerships mostly make long-term equity investments, most of their profit is long-term capital gain.

What do general partners do to earn their carried interest? It’s an intensely entrepreneurial business. They invest about $1 million of personal money and work for a year to organize a partnership. Then they put millions more into the partnership’s capital and work for 4-5 years to find talented entrepreneurs with promising ideas and close investments with them. They work alongside the entrepreneurs as partners (investors, board members, and mentors) for 5-10 years to help their companies become successful. Many VC funds are never profitable and only 25% are strong performers. If and when all this works out the GPs get paid carried interest.

Those are the facts. My goal here is to lay out what carried interest is, how it works, and the business logic behind it. Now, let the politicking begin.

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