Carried interest is a “critical mechanism for aligning GP and LP interests”, according to the Washington, DC-based Institutional Limited Partners Association, which represents the interests of institutional investors in private equity.
Carried interest or carry is the share of profits the general partner of a buyout fund gets to keep beyond a pre-agreed rate of return threshold known as the “hurdle rate”. Carry is typically set at 20 percent; the remaining 80 percent of profits is turned over to the limited partners, who provide the capital.
ILPA reiterated its stance after Republican presidential candidate Donald Trump said in a speech on 8 August that as part of his tax reform package, his administration would “eliminate the Carried Interest Deduction and other special interest loopholes that have been so good for Wall Street investors, and people like me, but unfair to American workers”.
ILPA stopped short of explicitly opposing increased tax on carry, but said its focus is on “ensuring that interests are aligned between GPs and LPs with respect to any fee or incentive gain, regardless of how it is taxed.”
“When the broader economic arrangement between GPs and LPs, inclusive of both carried interest and fees, is optimised for alignment of interests, it can create the right incentives for private equity to contribute to its historical success as a high-returning asset class in LPs’ portfolios,” ILPA said. “Maintaining focus on alignment of interests ensures proper stewardship of these investments and allows private equity to thrive in a way that benefits all participants.”
Earlier this week, the American Investment Council, which advocates on behalf of the US private equity industry, criticised Trump’s plan to end favourable tax treatment of carried interest. Mike Sommers, president and chief executive of the Washington, DC-based American Investment Council, said that Trump’s speech “demonstrates a lack of understanding of what carried interest is and the critical role of private equity in the US economy”.
Currently, carry is treated as capital gains rather than as wages, and therefore attracts a lower rate of tax. Investment managers who receive carry pay a rate of 23.8 percent in federal personal income tax on these profits; that’s a 20 percent tax on net capital gains and an investment tax of 3.8 percent. If carry were treated the same way as wages, however, it would be taxed at the highest possible rate of 43.4 percent, or a 39.6 percent tax on net capital gains tax and an investment tax of 3.8 percent.
Making carried interest, rather than fees, the primary means of rewarding GPs is the best method for ensuring that LP and GP interests are in sync, ILPA said in its Private Equity Principles , a set of recommendations focusing on the relationship between the two parties.
“Alignment of interest between LPs and GPs is best achieved when GPs’ wealth creation is primarily derived from carried interest and returns generated from a substantial equity commitment to the fund, and when GPs receive a percentage of profits after LP return requirements are met,” ILPA said. “GP wealth creation from excessive management, transaction or other fees and income sources, reduces alignment of interest.”
ILPA counts as members over 300 public and corporate pension funds, endowments, foundations, family offices, and insurance companies managing over $1 trillion of assets. It provides education programmes, independent research, best practice recommendations, and networking opportunities.