Carried interest is a type of compensation or money paid to private equity or hedge fund managers. It is separate and distinct from the standard management fee a fund manager commands. It is essentially a performance-based form of compensation based on the profits of the investments, and it is designed to create a vested interest in the fund manager with regards to the fund performing well.
A hedge fund or private equity manager collects money from a group of investors and then invests that aggregate of funds. In many ways, it is similar to a mutual fund in which many people pool their money and that larger amount of money is invested in many stocks, allowing an investor to diversify his risk and get the benefits of large-scale investing even if he has a small amount of money. A hedge fund or private equity fund, however, is generally more restrictive than a mutual fund with regards to whom is permitted to invest. Hedge funds are normally available at investment banking houses known as "boutique" firms that cater to wealthy clients, and large initial buy-ins may be required to invest in a hedge fund.
Once the private equity or hedge fund manager has collected the money from investors, he then invests it in stocks, bonds or other investments in relation to the goals of the fund and its investors. The general goal is to provide a good return on investment for those who put their money in, but some funds invest more in growth stocks or emerging markets or approach the investment process differently. The manager of the hedge fund, however, is meant to have an interest in helping make the fund grow and in ensuring he invests as carefully as possible.
Carried interest is designed to give the hedge fund manager the extra incentive to be truly invested. While a hedge fund manager may receive a payment simply for carrying out his duties in managing the fund and buying stocks, often the bulk of his compensation comes from a carried interest payment. Carried interest is the percentage of the fund's profits or gains that he keeps. This percentage can be as high as 20 or 25 percent.
Because the more the fund makes the more he earns, a hedge fund manager's goals are thus perfectly aligned with his investors. He directly profits or benefits when the fund goes up. A payment of carried interest can potentially be in the millions of dollars depending on the size of the fund and the growth, so it provides a great deal of incentive to do as well as is possible at investing.