By Steve Novakovic, CAIA, CFA, Managing Director of Educational Programming, CAIA Association
As a limited partner, we live in the world of net returns. Gross returns are all well and good, if the LP can negotiate more favorable fees and narrow the gap between gross and net. But ultimately, irrespective of the fee arrangement, net returns are what LPs earn. GPs, on the other hand, make their living on incentive fees, also known as carried interest. Or at least they should. Some GPs today seem to make their living from management fees, but that’s a conversation for another post.
Let’s take a moment to dissect the incentive fee. LPs commit capital to a fund. The fund manager invests the LPs’ capital in a number of investments. To ensure appropriate alignment of interests, reward skill, and incentivize appropriate risk taking, LPs pay the fund manager a portion of the profits generated from the LPs' gross return. In this case, the GP’s investment is their time and expertise. There is no monetary investment by the GP, so the carried interest is akin to a bonus, or a tip for a job well done. The carried interest earned by the GP comes directly from the LPs’ capital.
Yet, the current tax code in the U.S. treats carried interest as a capital gain. And in private markets this is almost always a long-term capital gain. Based on current tax rates, this is a great outcome for GPs. The alternative, treating carried interest as ordinary income, would be far more punitive from a tax perspective. If you think of carried interest as a bonus or tip, then it would make sense for it to be taxed as income. Think about this: many LPs pay performance-based bonuses to their employees. These employees choose fund investments and are rewarded for selecting higher performing funds. The employees didn’t invest any of their own capital, yet any performance-based bonus will be taxed as ordinary income. Exact same concept, different tax treatment.
For decades, politicians have described the tax treatment of carried interest as a loophole. Obama, Trump, Biden, and now Trump again, have all called for the loophole to close. Yet it hasn’t. Let’s sidestep that political landmine and ask: why shouldn’t it be closed? According to trade groups representing GPs, the answer is that closing the loophole would stifle investment. Why would that be the case? Changing the tax code on carried interest wouldn’t change the gross return. It also wouldn’t change the net return. What it would change is the size of the after-tax “bonus” earned by the GP. In other words, the trade groups are implying that the GP makes investment decisions based primarily (perhaps exclusively, in some cases) on how large their after-tax bonus will be. Therefore, GPs would skip over investments they currently make, simply because it wouldn’t result in a large enough bonus.
I was under the impression that GPs looked for investments that would meet their target net return. GPs raise funds telling LPs that the goal of the fund is to earn a 20% net IRR, for example. A higher tax rate would not change the net IRR earned by the LP. Or perhaps the GP claims they target a 30% gross IRR. LPs can do the math as to what that means for a net return and decide whether that is attractive to them. It’s still the case that a higher tax rate does not change the gross return earned on the investment.
What a higher tax rate does change is how much profit the GP gets to keep for themselves after taxes, pure and simple. The only way to offset higher taxes (all else equal) is to either increase the incentive fee rate or to target a higher return. Since raising the incentive fee is impractical for nearly any GP, the implication must be that if GPs don’t want to compromise their after-tax earnings, they would have to target higher returning investments and generate more profits to earn a bigger bonus.
I suppose that’s where the threat comes in, that GPs would narrow their investable universe, and “lower” returning investments would be passed over. On the surface, you could make an argument that this is a good deal for LPs. After all, why would anyone complain about higher returns? But wait... if it’s that simple, why don’t GPs target higher returns already? What about the fact that targeting higher returns means taking on more risk (perhaps even excessive risk)? Isn’t the incentive fee supposed to create an alignment of risk? Frankly, I just don’t buy it.
I think it would be great to close the carried interest loophole, not because I wish GPs made less after-tax earnings, but because I’d like to see which GPs decide that their after-tax earnings are the most important factor in the investment process. Then LPs can really see which GPs have a client-first mindset and which GPs are in it exclusively for their own benefit. Maybe the trade associations were onto something. Closing the carried interest loophole would stifle investment, just not in the way that they portray it. It would stifle investment to GPs who are selfish actors.
Unlike the trade associations, I don’t think this reduction in investment activity would be harmful to small investors across the U.S. In fact, I think quite the opposite: closing the loophole would be great for small investors across the U.S. Let’s make it that much easier for LPs to weed out bad actors and shine a spotlight on the GPs who are truly aligned with their LPs’ interests.
About the Contributor
Steve Novakovic, CAIA, CFA is Managing Director of Educational Programming for CAIA Association. He joined CAIA in 2022 and has been a Charterholder since 2011. Prior to CAIA Association, Steve was a faculty member at Ithaca College, where he taught a variety of finance courses. Steve started his career at his alma mater, Cornell University, (B.S. 2004, MPS 2006) in the Office of University Investments. In his time there, he invested across a variety of asset classes for the $6 billion endowment, generating substantial insight into endowment management and fund investing across the investment landscape.
Learn more about CAIA Association and how to become part of a professional network that is shaping the future of investing, by visiting https://caia.org/
References
https://www.axios.com/2025/02/07/trump-carried-interest-tax-deduction
https://www.cbsnews.com/news/trump-tax-taxes-carried-interest-loophole-hedge-funds/