Private equity firms have two main ways of making money:
First Up, Management Fees: They typically charge around 2 percent of the committed capital as an annual management fee. This fee covers the operational costs of running the firm.
Secondly, Carried Interest: This is their share of the profits, usually 20 percent of the returns above a certain threshold (called the “hurdle rate”).
Despite this being compensation for the work done by the general partners, it’s not taxed as ordinary income. Instead, it’s treated as capital gains.
Why does this matter? Because in many countries, including the United States, long-term capital gains are taxed at a lower rate than ordinary income. For high-income earners, the difference can be substantial. As of 2024, the top federal income tax rate in the U.S. is 37%, while the long-term capital gains tax rate tops out at 20%.
This means that the general partners in a Private Equity firm often pay a lower tax rate on a significant portion of their earnings than they would if it were treated as regular income. This is what’s known as the “carried interest loophole.”