This article is reprinted with permission from the
August 29 , 2007
edition of
New York Law Journal.
2007 NLP IP Company.

Compensating Managers of Private Equity Funds

This column considers the compensation of executives who manage private equity funds that invest in a select group of companies, typically called "portfolio companies." It focuses especially on the profits interests, sometimes called "carried interests" or "incentive fees," allocated to such executives.

The portfolio companies, after a period of being held by the private equity fund, generally are taken public or sold to other businesses or investors.[1] Through their profits interests, the executives share in the gains from such dispositions.

Typical Structure

Accompanying this column is a chart depicting a typical structure involving a private equity fund, its managing partner and the portfolio of companies acquired by the fund. The private equity fund (the fund), in the example shown in the chart, is a limited partnership.[2] A separate entity manages the fund, oversees operation of the companies acquired by the fund and then negotiates the sale or other disposition of such companies. The chart shows the general partner, here a limited partnership, as manager of the fund but, alternatively, a partnership affiliated with the general partner might be the manager. (This alternative of an affiliate providing the services is shown by the dotted line box in the chart.) The limited partners of the general partner include the individuals who are the actual managers of the fund. (These individuals generally receive a profits interest in the general partner to the fund which, in turn, has received its profits interest from the fund itself.)


Chart:  Example of Structure Associated with a Private Equity Fund

*      The limited partners of the General Partner typically are individuals who oversee the management of the Private Equity Fund including its portfolio companies.
**   The General Partner and the private equity fund typically are limited partnerships, but either may be organized as another form of pass-through entity for tax purposes (such as an LLC).  Changes in the form of organization of either entity will change the structure from that shown in the chart.
*** In this alternative, an entity affiliated with the General Partner acts as manager and receives the management fees.

Two types of fees are paid by the fund: a management fee and an incentive fee (the latter being the profits/carried interest referred to above). The management fee typically is an annual fixed fee equal to 2 percent of the committed capital. (This fee may be paid to the general partner if it is the manager or it may be paid to an affiliate of the general partner if the affiliate is the manager (again, see dotted line box in the chart).) The incentive fee, or profits interest, typically is a 20 percent interest in the gains and other income realized by the fund. (In some cases, a hurdle return to the investors must be achieved before the general partner receives any payment on the profits interest.)[3]

A partnership interest in the fund results in the gains (losses) of the fund, attributable to the investments made by the fund, flowing through for tax purposes to the partners of the fund. Capital gains attributable to a sale of a portfolio company by the fund pass through to the partners in the fund, including the general partner, as capital gains.

The general partner's profits interest is, in turn, typically divided up among the partners making up the general partner. For purposes of this discussion, it will be assumed that the profits interest is shared equally among four individual limited partners. (It might be expected that the general partner would share in the profits interest but for purposes of this discussion that is not assumed.) Each limited partner of the general partner in this example would have a 5 percent profits interest (1/4 of the 20 percent profits interest held by the general partner). As the fund's income, including gains, is "passed through" for tax purposes to the general partner (20 percent profits interest), it, in turn, is passed through to the four limited partners (each having a 5 percent (1/4 of the total) profits interest).

If the fund disposes of a portfolio company and realizes capital gains of $100x, each limited partner of the general partner would realize capital gains of $5x. Assuming the long-term capital gains holding period (one year) is satisfied by the fund, the gains would be taxed, for federal income tax purposes, at the long-term capital gains rate (currently a 15 percent maximum rate) to each limited partner of the general partner. This contrasts to an individual ordinary federal income tax (marginal) rate of 35 percent on wages and other compensation for services. In the case of compensation awarded to employees, in addition to ordinary income tax rates there are withholdings for Medicare, Social Security and, in some cases, state and local wage-related taxes.

A profits interest received by a limited partner in the general partner will not be taxable to the individual limited partner, either when granted or when it later vests, provided that the profits interest satisfies certain conditions as provided in Internal Revenue Service (IRS) Revenue Procedure 93-27 and Revenue Procedure 2001-43.[4] Thus, in the example given, the four limited partners receiving the profits interests in the fund will not be taxable upon receipt of their profits interests (assuming the requirements of these two revenue procedures are met). Instead, the limited partners will be taxed at the time the gains and other income are realized in respect of the portfolio companies and passed through to them pursuant to their profits interests (and, presumably, they will be allocated any losses for tax purposes as well (subject to applicable rules as to deductibility)).

Difficulty in Valuing

The treatment of profits interests in these revenue procedures is based, in part, on the IRS's recognition of the difficulty in valuing the grant of a profits interest in a partnership in which the gains or other income is uncertain as to timing and amount.[5] In 1971, and again in 1990, the U.S. Tax Court agreed with the IRS and held that a profits interest granted to a partnership for services should be taxed at the time of receipt. In the first case, Diamond v. Commissioner, the U.S. Court of Appeals for the Seventh Circuit agreed with the Tax Court that the profits interest was taxable at the time of receipt and that it was, under the facts and circumstances, an interest that could be valued at that time.[6]

In the other case, Campbell v. Commissioner, the U.S. Court of Appeals for the Eighth Circuit reversed, in part, the Tax Court.[7] The Eighth Circuit held that even if such an interest was taxable at the time of receipt, it could not, in the circumstances present in Campbell, be valued. Following the second case, the IRS adopted Revenue Procedure 93-27 in an effort to establish guidelines for determining when a profits interest would not be taxable at time of grant (essentially, it is not taxable in circumstances in which the value of future income is not readily ascertainable at the time the profits interest is granted).

Underlying policy considerations appear to affect regulators' conclusions as to the technical issue of whether certain economic interests (such as a profits interest in a partnership) can be valued at time of grant. For example, a stock option is not taxed at time of grant because, under applicable regulations, it does not have a readily ascertainable value.[8] On the other hand, in December 2004, the Financial Accounting Standards Board determined that the value of an employee stock option at time of grant was sufficiently ascertainable to justify a charge to earnings at that time for purposes of general accounting principles.[9]

Legislation has been introduced in the House of Representatives for the purpose of amending the Internal Revenue Code to treat as ordinary income the gains allocated to partners under profits interests granted to them as compensation for performing investment management services.[10] During July, after much publicity about the extraordinary levels of income of managers of certain investment funds, Congress held hearings that addressed the lower long-term capital gains rate that accompanies the payouts on the profits interests held by the limited partners in private equity funds.[11]

The debate currently taking place over the taxation of gains attributable to profits interests is between those who urge that income tax rates be consistently applied to individuals earning personal service income regardless of how they earn it and those who argue that taxation of gains attributable to profits interests as ordinary income would discourage risk-taking by the individuals who are at the center of private equity fund enterprises. While feasibility of the valuation of profits interests in a partnership at time of grant is imbedded in the debate, the clash is really over policy considerations just noted. Tax and accounting history indicates that whichever point of view prevails in the policy debate, the technical issues (such as valuation of profits interests) will, if necessary, be "resolved" on a basis consistent with the conclusions as to policy.[12]

It should be noted that the individual managers/limited partners of the general partner (in the example set out in Chart 1) also receive compensation in the form of salary and annual bonus. As in most investment firms, the salaries tend to be relatively low with annual bonus opportunities at a significantly higher level (although not generally equivalent to those paid to top executives at investment banks). The principal objective of private equity funds investing in portfolio companies is the realization of gains associated with the disposition of portfolio companies and awards associated with such dispositions (the profits interests) tend to be the primary economic reward.

Different types of investment firms, of course, have different objectives. For example, hedge funds are dependent on successful hedging in long and short positions, rather than in the periodic disposition of portfolio companies and, in consequence, the annual incentives can be very substantial. Thus, the mix of economic opportunity (i.e., cash compensation (salary and bonus) and long-term awards (such as a profits interest) will vary significantly among different investment firms.

More 'Private Equity' Cases

Compensation of individuals in two other forms of private equity are noted: funds of funds and, at the other end of the investment "chain," the portfolio companies that are the object of investments by the private equity funds.

Funds of Funds. These are funds that are like the private equity fund in the chart except that they invest in other private equity funds. Their purpose is to give their investors greater diversity than can be achieved by investing in just one private equity fund and to provide investors with the expertise of the managers of the funds of funds in choosing among private equity funds. A typical fund of funds fee arrangement with its general partner might be a 1 percent management fee and a 10 percent profits interest (the latter being taken out of the fund of funds' capital interests in the private equity funds in which it invests). (As discussed in connection with private equity funds, sometimes the general partner's profits interest is subject to a hurdle return to investors). Again, among different funds of funds these percentages may vary, including allocations between management fees and profits interests. Like the example in the chart, the profits interests of the limited partners of the general partner of a fund of funds, who are the individuals managing the fund of funds, appear to be allocated out of the general partner's interest in that fund.

Portfolio Companies. In most portfolio companies, the CEO is compensated by a combination of salary, annual bonus and long-term incentive, the latter typically in the form of restricted stock or stock options in the portfolio company. Restricted stock units also are used in some cases. Some of the equity may be subject to performance targets.

In these respects, the categories of compensation of an executive in a portfolio company are similar to those of executives in privately and publicly owned companies generally. Greater emphasis tends to be placed on the equity opportunity than in the current cash compensation. In part this is so because of the desire to preserve cash. It also reflects the long-term interest in disposing of the portfolio company at a substantial gain and rewarding performance in support of that goal (a similar circumstance to that described above in connection with the compensation of executives managing a private equity fund (i.e., the limited partners of the general partner to the fund in the example described in the chart)).


The implosions of many so-called "Silicon Valley" companies in the early 2000s suggest some of the risks involved in terms of ultimate realization of equity value in a portfolio company. Delay in realizing the value and other conditions associated with the equity further diminish the "real" present value of many equity awards.

Finally, it is noted that gains attributable to stock options and other equity awards in a portfolio company, if and when realized by the executives of that company, are almost always taxed at ordinary income rates (in contrast to the long-term capital gains tax treatment of the profits interest held by the limited partners of the general partner to the fund holding the portfolio companies in the example described in the chart).[13]


1. Among the numerous private equity funds are funds that focus on start-up companies, on mature company "turnarounds" and on distressed companies, among others. Another category of fund is the so-called "hedge fund" which specializes in investing (most often on a short-term basis) to take advantage of moves in different securities and other investments that often run counter-directional to one another. Estimates are that, worldwide, as of the end of 2006, private equity funds managed approximately $1 trillion in assets and hedge funds controlled assets in excess of $1.4 trillion. For a discussion of these two types of investments, see Joint Committee on Taxation, Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests, (JCX-41-07), July 10, 2007.

2. Limited liability companies (LLCs) and other forms of pass-through entities are also vehicles for private equity funds. For a discussion of the basic structures associated with private equity funds, see Andrew W. Needham and Anita B. Smith, "Private Equity Funds, 735 Tax Mgmt." (BNA) p. A-3.

3. There is no set pattern for these fees. For example, in addition to the management fee, the managers may earn transaction fees for making acquisitions (investments in portfolio companies). Sometimes management fees are reduced and the profits interest is increased.

4. Rev. Proc. 93-27, 1993-2 C.B. 343. Rev. Proc. 2001-43, 2001-2 C.B. 191. In 2005, the IRS issued proposed regulations relating to the tax treatment of equity transferred to partners in exchange for services provided by the partner to the partnership. The proposed regulations, when finalized, would make Rev. Procs. 93-27 and 2001-43 obsolete. Partnership Equity for Services, 70 Fed. Reg. 29675 (May 24, 2005).

5. As pointed out in the recent congressional hearings, those receiving "carried interests" in mineral properties received in consideration for services provided by geologists and developers in exploring for and developing mineral properties have been taxed only on income realized from production or upon sale of the underlying property. See Testimony of Treasury Assistant Secretary for Tax Policy Eric Solomon Before the Senate Finance Committee on the Taxation of Carried Interest, 110th Cong. (July 11, 2007).

6. Diamond v. Commissioner, 492 F2d 286 (7th Cir. 1974), aff'g 56 T.C. 530 (1971)

7. Campbell v. Commissioner, 943 F2d 815 (8th Cir. 1991), aff'g in part, rev'g in part, 59 T.C. 236 (1990)

8. Internal Revenue Code §83(e)(4); Treas. Reg. §1.83-7.

9. Share-Based Payment, Statement of Financial Accounting Standards No. 123 (revised 2004) p. iii (Financial Accounting Standards Bd. 2004).

10. H.R. 2834 (110th Cong. First Session, June 22, 2007). Earlier in June legislation was introduced in both the House and the Senate to provide that publicly traded partnerships which directly or indirectly derive income from providing investment advice and related asset management services are to be treated as corporations under the Code. S. 1624 (110th Cong. First Session, June 14, 2007) and H.R. 2785 (110th Cong. First Session, June 20, 2007).

11. Senate Finance Committee Hearings, Carried Interest, Part I, July 11, 2007 and Carried Interest, Part II, July 31, 2007.

12. In the middle of the debate in Washington, a number of alternative theories for the taxation of a profits interest have been discussed. For a discussion of such alternatives, see Victor Fleischer, "Two and Twenty: Taxing Partnership Profits in Private Equity Funds, Pt. V" (Legal Studies Research Paper Series, Working Paper Number 06-27, June 12, 2007).

13. An executive receiving an unvested equity award is usually taxed on an ordinary income basis on the value of the award at the time it vests. The executive may make a Code §83(b) election to pay tax at the ordinary tax rate on the value at the date of the grant and then to have any future increase in value of the award taxed at the capital gains rate when the value is finally realized.