If you have been living under a rock for the past several years (and especially the past few months during the race for the Republican presidential nomination), you might not be aware of the great debate surrounding the taxation of carried interest. At issue: Is carried interest an investment that should continue to receive preferential capital gains, instead of ordinary income, tax treatment?  

Based on the extensive press coverage of this issue, I realized that most of the analysts incorrectly assume everybody already knows what carried interest is and how it is created. Some detail as to how private equity and venture capital funds are structured would be helpful and lead to a better understanding of what carried interest really is. Then everyone can form their own informed opinions about how it should be taxed.  

The devil in the detail. Private equity and venture capital funds typically are structured as limited partnerships with a lifespan of 10 to 14 years. The general partner (e.g., Bain Capital) finds limited partners that will invest capital in a fund to be used to make private equity and venture capital investments in operating companies around the world. The general partner typically invests a bit of its own money as well, usually 1 percent of the total invested by the limited partners. Then the general partner does all of the work, while the limited partners sit back and hope for a great return on their investments.  

The general partner gets compensated for its efforts in two ways: a management fee and carried interest. Paid annually, the management fee is usually set at 2 percent or 2.5 percent of the capital invested in the fund by the partners. So, no matter how well (or poorly) the fund’s investments perform, the general partner will receive the management fee. Just to show my math, for an average-sized fund of $500 million with a 2 percent management fee, $10 million gets paid to the general partner every year as its management fee. Of course, for the largest of funds, which are reaching $10 billion in size, that management fee would be up to $200 million per year.  

Over the life of the private equity or venture capital fund, the amount of capital invested in it will decrease as certain investments are cashed out and repaid to the limited partners. Those annual $10 million (or $200 million) payments to the general partner will be reduced proportionately. In addition to that decrease, some general partners will have agreed to lower their management fee to 1 percent or 1.5 percent after the first six or seven years once they are no longer actively searching for and investing in portfolio companies; instead, they will be preparing the companies to be sold during the second half of the fund’s life so that the proceeds can be returned to the partners.  

Which brings us to the carried interest. Even if a general partner invests 1 percent of whatever amount the limited partners invested, the carried interest gives the general partner extra credit – as if it had invested 20 percent of the total size of the fund. The general partners of some very large funds receive a carried interest of 25 percent or even 33 percent. And, like the management fee, the amount of carried interest may be negotiable when the private equity or venture capital fund is being formed, especially if certain large limited partners have enough bargaining power to refuse to invest in the fund unless the general partner reduces its compensation structure.  

It comes down to this: The limited partners invested 99 percent of the money used by the fund to make its investments in operating companies, but they receive only 80 percent (or less) of any profit generated by the fund when it sells those portfolio companies. In contrast, the general partner has invested 1 percent of the money but receives 20 percent (or more) of the profit generated by the fund. But all of the partners receive the same reduced capital gains taxation treatment on income they receive from the fund.  

General partners argue that they deserve this preferential treatment on the 20-percent “extra credit” carried interest because they put in the time, energy and expertise to grow the portfolio companies in which the fund invested. Of course, the general partners are still receiving their management fees. And not every investment ends up being a success story for the investors or the portfolio companies as a whole.  

Impact. If the tax code is revised so that carried interest is taxed as ordinary income instead of capital gains, what impact will that have on the private equity and venture capital markets? Will general partners walk away from the opportunity to invest in new portfolio companies and, as a result, cause a slowing in the creation and growth of businesses? Or, similar to a banking industry searching for new fees and other sources of revenue, will general partners simply pass their increased costs on to their customers by increasing their management fees and/or percentage of carried interest, or by lowering their pre-money valuations of the portfolio companies so that the projected returns on investment will remain the same? (Hint: Many recently formed private equity and venture capital limited partnership agreements already include a new provision that anticipates any changes to the tax code and protects the general partner so that it will still receive the same economic benefit as if the carried interest had continued to be taxed at the lower capital gains rate.)  

While these questions may appear to be a separate debate for another day, “answers” to them are influencing the debate right now.