Carried interest: A closer look

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Carried interest: A closer look

Carried interest: A closer look

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May 21, 2024

In fund formation exercises, the approach taken to the structuring and payment of carried interest is a discipline in and of itself. There is a significant degree of contractual freedom which leaves room for tailored arrangements, but which also presents challenges for the fund manager and the carried interest recipients. This note takes a closer look at the structuring of carried interest arrangements in fund structures and the associated challenges, including from an employment and tax perspective.

What is carried interest?

Put simply, carried interest represents a portion of the share of profits of a fund's investments paid to a fund manager in connection with its fund management activities. Typically, the fund manager will receive a management fee as a percentage of assets under management (typically 1 or 2% of AUM). In addition, in a classic fund waterfall, the fund manager will also be entitled to a portion (20% is the norm) of the profits on investments after investors have received back their commitment plus a preferred return (8% preferred return is typical). It is this allocation of profits that represents the carried interest. The fund manager will then decide how to apportion carried interest between its team members, in order to promote retention and incentivise performance. When considered from an employment perspective, carry is a valuable status indicator and can be a key attraction for individuals.

Carried interest structures

There are various ways in which carried interest can be extracted from the fund and into the hands of the carried interest recipients. It is common to see a "special limited partner" set up that will act as the carried interest vehicle. The special limited partner will be a limited partner in the fund alongside the investors. The carried interest will accrue to the special limited partner, and the partners in that vehicle will share in the carried interest according to agreed terms.

In a UK context, English limited partnerships are often the vehicle of choice for private fund structures. An English limited partnership cannot be a partner in another English limited partnership, due to its lack of legal personality. A Scottish limited partnership does, however, have that legal personality and can be a partner in an English limited partnership. For this reason, the special limited partner in the UK is often a Scottish limited partnership. There are other ways in which carry can be extracted, such as it might be payable directly to the general partner of the partnership, but the special limited partner route is most common.

Carried interest recipients

A limited partnership agreement (LPA) for a fund will typically identify "Key Persons". Investors will want confidence that Key Persons spend an appropriate amount of time dedicated to the affairs of the fund in which they are invested. Often these Key Persons will be entitled to a portion of the carried interest, although it is not uncommon for other members of the management team, or consultants or employees, to also participate in carry. Where carry recipients are also employees, careful consideration should always be given to dovetailing employment and carry documentation, including around obligations of the employee to the fund manager/fund. For example, it is important that any post-termination restrictions on employees are consistent with the fund terms.

The fund LPA will set out the entitlement of the special limited partner to carried interest and other rights and obligations of the special limited partner. Typically, the intricacies of carry entitlement are not visible to investors, but investors may request that a minimum percentage of carry is due to the manager and its affiliates (to the exclusion of any other person).

Typical carried interest terms

The following are typical carried interest terms:

Leaver provisions: A good/bad/other leaver framework is common. Carried interest represents a key tool for fund managers to retain talent and incentivise performance. If a leaver is a good leaver (for example, because leaving is due to circumstances outside the individual's control such as redundancy or long-term illness), there may be no negative impact on their carry entitlement as a consequence of that individual becoming a leaver. By contrast, if an individual commits fraud or breaches restrictive covenants, for example, they may be treated as a bad leaver and suffer a reduction in their carried interest entitlement as a result. More recently, we have seen organisations seeking to include certain aggravated misconduct within bad leaver provisions, to catch acts of sexual harassment or other serious and reputationally damaging behaviour. "Other leaver" status allows fund managers to cater for unexpected leaver scenarios with some flexibility. Where carried interest recipients are recipients in multiple schemes, it can be helpful to designate bad leavers or defaulters as having that status across all structures in the event that they are designated as a bad leaver or a defaulter under a particular regime. Again, it is important that carry provisions are not considered in isolation and that early advice is taken in the broader context of any termination of employment or similar engagement. When drafting settlement agreements, carried interest should be expressly contemplated.
Employment contract: It can also be prudent to include express terms in the employment contract to exclude the company's liability for loss of an employee's rights to carried interest caused by any termination of employment – the aim being to limit liability in the event of a wrongful dismissal.
Vesting provisions: Entitlement to carry is often staggered over a number of years, again with a view to retention and performance, but also in recognition of a fund's lifecycle where it may take years for value to accrue. It is common to provide that if a would-be carried interest recipient leaves their role within the first year of commencing duties (the "cliff period") they will not be entitled to any carried interest and will forfeit any accrued entitlement. Vesting periods vary between three and ten years, but seven years would be pretty standard. Straight-line vesting, where entitlements accrue at a constant rate throughout the vesting period, is most common, but there are variations with vesting being staggered in other cases. For example, founders may receive preferential and accelerated vesting terms. In an employment context, we have seen examples of the general partner being entitled to withhold the payment of carried interest prior to a leaver's "Exit Date" (to encourage positive behaviour during notice periods etc.).
Impact of general partner removal: If a general partner is removed from acting in that capacity in connection with a fund, there are typically economic consequences for the general partner. The consequences customarily depend on whether the general partner has been removed with or without cause (i.e. fault). With a for-cause removal, usually any entitlement to accrued or future carry will immediately be forfeited. In the case of removal without cause, often the fund manager will continue to be entitled to carry for the period it was in office, perhaps with a percentage discount applied (a "haircut"). The manager will not typically be entitled to any carry in respect of any activity carried out after its removal in either scenario.
Giveback: If the investors in the fund are required in certain circumstances to return distributions (for example, to meet indemnification obligations), the special limited partner will often also be subject to those giveback obligations. In order that the special limited partner can meet those obligations, the carried interest recipients would then be subject to mirror giveback obligations. Giveback provisions are typically understood by carried interest recipients (even if they are more familiar with them in a bonus context). However, in drafting carry and employment documentation, consideration should be given to deductions clauses and, particularly, what happens if the carried interest recipient is not in receipt of funds to return at the relevant time.
Regulation: In the FCA's view, carried interest structures will generally not be an "alternative investment fund" (AIF) because the employee participation scheme exclusion will often apply. The exclusion applies because a scheme for carried interest participation allows the employees to benefit from the success of the management undertaken by the employer. Family members of an employee, or trustees of an employee's family trust, may also participate in the carried interest vehicle on this basis without that vehicle becoming an AIF. The vehicle may also fall outside the definition of an AIF if it does not carry out capital raising. If employees only invest a nominal amount of capital, the undertaking does not meet this criterion because the employees are not investors. An employee is not investing their salary (by being remunerated in part by way of an interest in the vehicle) if it is a term of their employment that they would be remunerated with an interest in the vehicle.
Governance: Carried interest arrangements need to have in-built flexibility to cater for changes over time (leavers, joiners, star performers, transfers etc.). It is therefore often prudent to have an adjudication committee (or similar) vested with a reasonable degree of discretion to make sure the carry arrangements can operate effectively over time.
Transfers: Because carry is often a recognition of a particular seniority or expertise, it is usually a personal entitlement which cannot be transferred without the consent of the fund manager. Carried interest recipients may make separate arrangements to allow family members to receive a share of their entitlement. There is often a portion of carry that is held by the manager and which the manager can transfer freely to accommodate leavers, joiners and star performers. Consideration should also be given to the impact a TUPE transfer may have on carried interest and vesting.

Tax

Objectives

Tax considerations play a very important part in the design of a carried interest arrangement.

From the perspective of the carry participants and their employer, there are typically two key objectives:

to minimise any liability for tax and social security contributions on the grant and vesting of the carried interest; and
to ensure that the returns on the carried interest are not taxed as employment income, but as capital gains (or, in some cases, as investment income).

The following paragraphs provide an outline of the UK tax regime for carried interest as it applies to UK tax resident managers.

Employment taxes

In the UK context, the award of carried interest to an employee by means of the issue or transfer of an interest in the special limited partner will be treated as a form of benefit-in-kind, subject to the special provisions of the employment-related securities regime.

While the value of the benefit will be subject to both income tax and employee's National Insurance contributions in the hands of the employee (and to employer's National Insurance contributions in the hands of the employer), HM Revenue and Customs should accept that the benefit has only a nominal value if both the timing of the award and the structure of the carried interest arrangements are aligned with the model structure described in the Memorandum of Understanding agreed between HM Revenue and Customs and the British Venture Capital Association on 25 July 2003.

Provided that the full "unrestricted" market value of the carried interest (i.e. disregarding leaver restrictions and other restrictions affecting the market value of the carried interest) has been taxed on acquisition (or paid by the employee), returns on the carried interest derived from the normal operation of the carry arrangements should generally fall outside the scope of employment taxes.

Anti-avoidance

In certain circumstances, anti-avoidance rules apply to treat sums derived by the management team from participation in a fund as a disguised management fee, subject to income tax and National Insurance contributions as a form of trading income, if the sums would otherwise be taxed as capital gains or investment income. Carried interest arrangements based on the model of the classic fund waterfall described above should ordinarily fall outside the scope of the anti-avoidance rules.

Members of the management team whose carried interest is not linked to an employment (which may include managers who carry on the management business as members of a limited liability partnership) may, however, be affected by rules on "income-based" carried interest. Under these rules, all or part of a carried interest return may be taxed as trading income to the extent it is derived from participation in a fund whose average investment-holding period is less than 40 months.

Special capital gains regime

Provided that a carried interest return is not taxed as employment income or as trading income under the anti-avoidance rules, it is subject to a special capital gains tax regime, under which:

the tax basis of the carried interest is calculated by reference to the actual consideration given by the members of the management team to acquire their carry and/or the amounts on which the management team have been subject to employment taxes (rather than their proportionate share of the base cost of the fund investments from which the carry is derived); and
the rates of tax payable (18% or 28%, depending on the amount of the manager's taxable income) are higher than the ordinary rates of capital gains tax (10% or 20%, respectively).

If the returns on the carried interest are derived from the fund's investment income, members of the management team will simultaneously be subject to income tax on that income at rates of up to 39.35% (in the case of dividend income) and 45% (in the case of investment income from other sources), but will receive credit for that tax against the tax payable under the special capital gains regime.

If, as would more usually be the case, the returns on the carried interest are derived from underlying capital gains of the fund, no further tax should be payable by the management team.