Modifying The Carried Interest To Do What It Is Said To Do

Abstract

The carried interest received by private equity fund managers (General Partners; GPs) generates some controversies. The three most debated claims are that carried interest i) aligns incentives, ii) should be treated as a capital gain for tax purposes, and iii) should not be reported as a fee charged to investors. The existence of two key principal-agent relationships within the private equity model might be at the root of these controversies. One relationship links the GP as principal and portfolio company management team as agent. In this first contract, the three claims hold true. The other relationship links fund investors (Limited Partners; LPs) as principal with the GP as agent. I show that modifying that second contract by introducing a first-loss feature and reducing significantly the catch-up rate makes the two contracts equivalent. Hence, the benefits of the limited partnership structure can co-exist in a setting where the three claims about carried interest hold true.

Keywords: private equity, incentives alignment, carried interest

JEL Classification: G24