What is the difference between performance fees and carried interest when talking about funds and compensation schemes?
I am not a tax lawyer or a CPA.
"Carried interest" is a specific type of "performance fee" that is charged by the General Partner of an investment fund as an incentive/reward for good performance of the fund. They are common in Private Equity, some Hedge Funds, maybe VC. (Keep in mind that performance fee arrangements differ, not all funds are partnerships (LLCs, Investment Companies (or 1940 Act companies), etc. also exist), and even partnerships can have different setups.
Suppose a partnership manages 100 million dollars, the general partner owns 10% and 18 limited partners own 5% each; you are one of these 18 partners. Suppose a year later the fund is worth 110 million dollars. You say great, everyone made 10% on their money. But not so fast, the fund made 10 million,but we have to take into account a performance fee of 20% of profits for the general partner. To do this, the accountant assigns the GP an additional "interest" (or quota, or share) in the fund so he now owns 11.636% of the fund, and the limited partners own 4.909% each.
What's going on? Your share is now worth 110*0.04909 or 5.4 million, which is a profit of 0.4 and a return of 6.2% on your initial capital of 5. The GP's share is 110*0.11636 or 12.8 million, a gain of 2.8 million. This 2.8 million can also be explained as follows: 1 million as a 10% partner, plus 20% of the other partners profit, i.e 0.2*9.
The beauty of this arrangement is that the IRS treats this as a capital gain for the GP. The GP argues that "I didn't take any money out, I am just reinvesting in the business, like a rancher who has more cattle at the end of the year than at the beginning. I am not going to be able to spend the money until I close out the fund [or sell the cattle to the slaughterhouse]. Until then I am just "carrying" my additional interest in the business forward". The critics disagree with this tax treatment, they say that a "capital gain" is when your shares of Exxon increase in value through no effort of your own; on the other hand the GP is receiving a reward for his efforts, which is the definition of compensation, and should be taxed as such. It is a complicated controversy and I have changed my mind over time as to who is right about the tax issue. But this is how it works as I understand it.