Carried interest is a bonus paid to fund managers, usually in private equity. It is a proportion (often as much as 20%, occasionally more) of returns above a hurdle rate. It is usually treated (in the US, the UK and many other countries) as a capital gain and tax is therefore paid on it at a lower rate than income tax.
The low taxation of carried interest is controversial and is therefore likely to change in most countries in the near future, but few changes have happened so far (as at February 2009).
The use of the word carried is slightly confusing as it refers to the managers being carried by investors in that they receive a share of profits without investing their own capital. This is very different from the use of the word carry with regard to financing costs versus income.
The motive for using carried interest arbitrage is that it gives managers a greater incentive to make large profits. Like most bonus schemes its effectiveness is unproven, but it is generally accepted in private equity. The use of hurdle rates may sometimes create an agency issue as managers lose little whether the return is a little below or a lot below (even negative) the hurdle rate. This may give them an incentive to take high risks when there is a likelihood of missing the hurdle rate.
The rate of return is usually the IRR of the investments. Carried interest is usually paid on a “whole fund” basis: managers are rewarded on the return of a fund as a whole. Some companies do pay carried interest on an investment by investment basis.
Fund managers will receive both a management fee and carried interest. Although this may seem excessive compared to the managers of portfolio investments in listed companies, private equity investment requires more work for each investment as managers are more involved in the running of companies they invest in. Nonetheless, this practice is one reason why managing private equity is so profitable.