A "carried interest waterfall model" is a term often used in private equity and real estate investments to describe a method for distributing the profits earned on an investment. The name "waterfall" comes from the way profits flow down to different types of investors in a series of steps or tiers. Here's a basic breakdown of how it typically works:
Relevant Templates:
- IRR Hurdle Waterfall Model (3 tiers)
- Preferred Return Waterfall Model (no IRR hurdles)
- Preferred Return Model (multiple hurdles, simple interest, non-compounding)
- Check out all joint venture templates here.
Carried Interest Split: Any profits exceeding the preferred return and the catch-up phase (some funds/groups use catch-ups and some don't, it is a preference) are split between the GP and the LPs based on the carried interest arrangement. Typically, this split is something like 20% to the GP and 80% to the LPs, but these percentages can vary. The GP or fund manager is usually who is referenced when you say carried interest. The most common phrase is 2 and 20, which means 2% fee on managed assets (usually per year) and 20% of any profits. In a waterfall model, the carried interest share can increase for the GP as certain hurdles are met for the LP (as the LP does better, the GP gets to keep more profits). These hurdles can be IRR, simple interest, compounding/non-compounding, and/or accrued/no accrual of unpaid pref.
There are many, many ways that a profit distribution model for joint ventures can be structured and there is no single right way as long as everyone agrees on what is happening. The key is to use accepted terms and a model can help demonstrate different scenarios and what happens to the distributions based on available cash flow.
Sometimes, the GP will earn a small percentage of the profits at the same time as the LP, but may have no asset management fee. If the GP contributed some funds, they may split the profits pari passu until certain hurdle rates are met, and then the GP may get a promote on their amount of carried interest.
In summary, a carried interest waterfall model is a structured approach to distributing investment profits, ensuring that all investors receive their initial capital and preferred returns before the general partner receives their share of the profits. This model aligns the interests of the general partner with those of the limited partners, as the GP usually only receives a substantial payout if the investment performs well.
Taxes and Carried Interest
Note, I am not a tax professional but simply have some experience talking with GPs about this topic and have done some research about this on my own. This is not advice, use at your own risk.
Capital Gains Tax vs. Ordinary Income Tax: Historically, carried interest has been taxed as a capital gain rather than ordinary income. This is significant because capital gains tax rates are typically lower than the rates for ordinary income. For example, in the U.S., long-term capital gains tax rates have been significantly lower than the top rates for ordinary income.
Reason for Capital Gains Treatment: The rationale behind taxing carried interest as a capital gain is that it is considered a return on an investment, rather than a salary or wage. Since the fund managers (general partners) are receiving a share of the profits from the investment, this income is treated similarly to how an investor's profits would be taxed.
Controversy and Debate: This tax treatment has been a subject of debate and controversy. Critics argue that carried interest is essentially a form of compensation for managing the fund and should be taxed as ordinary income. Proponents of the current system argue that carried interest is a return on investment and incentivizes fund managers to maximize performance.
Recent Changes and Proposals: There have been various proposals in the U.S. and other countries to change the taxation of carried interest. These proposals often aim to tax carried interest as ordinary income. In some cases, changes have been implemented, but the specifics can be complex and are subject to ongoing political and legislative processes.
International Perspective: The taxation of carried interest can differ significantly in other countries. Some may tax it as ordinary income, while others may have tax treatments similar to the U.S.
Holding Period Requirements: In some jurisdictions, the tax treatment of carried interest depends on the holding period of the underlying investment. For instance, in the U.S., the investment must be held for more than one year to qualify for long-term capital gains tax rates.
These rules can change over time, we all know the tax code in the U.S. has changes for more advanced financial structures all the time. Stay fluid.
Article found in Real Estate.
