Tax Implications of Private Equity Waterfall and Carried Interest Provisions

Gain a better understanding of a sponsor's 'carried interest' and explore how preferred returns are commonly calculated.

A key aspect of a private equity fund is the sponsor promote or carried interest, which is the sponsor's disproportionate share of profits in a deal above a predetermined (or preferred) return threshold. Relative to amounts invested, once the preferred return threshold has been met, residual cash flow distributions typically favor the sponsor. In general, the sponsor's carry is calculated on either a 'deal by deal' or a 'whole fund' basis. However, within this simple binary choice, there are myriad variations, any one of which can significantly alter the returns to sponsors and investors. This topic will define the sponsor's carried interest and explore the variations for structuring the carried interest. In addition, this material will address different structures and related security arrangements of sponsor clawbacks, which protect investors from sponsors receiving carried interest they have not earned. Finally, this information will address other tax considerations that pervade all fund agreements and can impact sponsor and fund returns, such as fee waivers and tax distributions.