Carried Interest and Management Fee Structures in Hong Kong Investment Funds

What Is Carried Interest?

Carried interest (or “carry”) is the share of a fund's profits that the general partner (GP) or fund manager receives as performance compensation, above and beyond the management fee. It is the primary incentive mechanism aligning the manager's interests with those of the fund's investors (limited partners or LPs).

The standard carried interest structure in the private equity, venture capital, and hedge fund industries is the “2 and 20” model: a 2% annual management fee on committed or invested capital, and a 20% performance allocation on profits above a hurdle rate. In practice, both components are actively negotiated, and market norms vary by asset class, fund size, and manager track record.

How Carried Interest Works

Carried interest is typically structured as a performance allocation (in partnership structures) or a performance fee (in fund company structures). In a standard private equity fund:

The fund invests capital in portfolio companies over an investment period. Upon exit (through sale, IPO, or recapitalisation), proceeds are distributed according to the fund's distribution waterfall. The waterfall typically provides that investors first receive a return of their invested capital, then a preferred return (the hurdle rate, typically 6-8% per annum), then a catch-up provision to the manager, and finally an 80/20 split between investors and the manager.

The “catch-up” mechanism allows the manager to receive a disproportionate share of distributions (often 100%) until the manager has received 20% of all profits to that point. This ensures that the final split between investors and manager is 80/20 on all profits above the preferred return.

Management Fees

Management fees are charged to cover the fund manager's operating costs — staff, rent, technology, compliance, and professional services — during the fund's life. Typical management fee terms include:

Investment period fees: During the investment period (usually the first three to five years), fees are charged as a percentage (typically 1.5-2%) of committed capital.

Post-investment period fees: After the investment period, fees typically step down to a lower percentage of net invested capital (the cost of remaining portfolio investments), reflecting the reduced workload as the fund is in harvest mode.

Management fees are generally offset against carried interest in whole or in part, reducing the carried interest otherwise payable to the manager. This offset (the “fee offset”) is a standard feature of LP-friendly fund terms and is increasingly required by institutional investors.

Hong Kong's Carried Interest Tax Concession

Hong Kong introduced a carried interest tax concession in 2021, designed to attract private equity and venture capital fund managers to establish their operations in Hong Kong. Under the concession:

Qualifying carried interest received by eligible fund management entities in Hong Kong may be taxed at a concessionary rate of 0% for salaries tax purposes (for individual employees and partners) or at half the standard profits tax rate (8.25%) for corporate entities.

To qualify, the carried interest must arise from a qualifying fund — which broadly includes funds that qualify for the SFC-managed fund tax exemption — and the fund must be managed by an SFC-licensed fund manager with adequate substance in Hong Kong. Investment activities must be carried out by individuals performing qualifying services in Hong Kong.

The concession is significant because it removes a key competitive disadvantage Hong Kong had relative to Singapore, which had long offered similar tax incentives for private equity managers. The availability of the concession is a key consideration for managers deciding where to base their fund management operations in Asia.

Waterfall Mechanics: European vs American Waterfalls

Private equity funds use one of two main distribution waterfall structures. The European waterfall (fund-as-a-whole or deal-by-deal with aggregation) provides that carried interest is only distributed once all invested capital and the preferred return have been returned to investors across the entire fund portfolio. This protects LPs from receiving carried interest on successful deals while losing capital on others. The American waterfall (deal-by-deal) allows carried interest to be distributed after each successful exit, giving managers faster access to performance compensation. Claw-back provisions protect LPs against overpayment of carry in early deals if later deals underperform.

Negotiation Points with Institutional Investors

Institutional LP investors (pension funds, sovereign wealth funds, endowments) typically negotiate hard on fee terms. Common LP requests include lower management fees, higher hurdle rates, 100% fee offsets, European waterfall structures, reduced carry on follow-on investments, most-favoured nation (MFN) provisions in side letters, and transparency in fee reporting. Emerging managers often face more pressure on fees than established managers with strong track records.

How Alan Wong LLP Can Help

Alan Wong LLP advises fund managers on the structuring and documentation of carried interest and management fee arrangements, including limited partnership agreement negotiation, GP and GP entity structuring, carried interest tax concession eligibility analysis, co-investment terms, and LP side letter negotiations. We assist both new managers establishing their first fund and established managers raising successor funds with updated economics. Contact us to discuss how to structure your fund's economics in a commercially competitive and tax-efficient manner.