Carried Interest and Performance Fee Structures in Hong Kong Private Equity and Hedge Funds

Introduction

Carried interest and performance fees are the primary mechanism through which investment fund managers participate in the returns they generate for investors. In private equity and venture capital funds, the carried interest (or "carry") represents the fund manager's share of profits after investors have received a preferred return. In hedge funds and other liquid funds, the performance fee (or "incentive fee") is calculated and paid at regular intervals based on the fund's investment performance. The design of these arrangements—including the hurdle rate, clawback provisions, high-water mark, and crystallisation mechanism—has a profound impact on the economics of the fund for both managers and investors.

In Hong Kong, carried interest and performance fee structures must comply with applicable regulatory requirements, including the SFC's disclosure and investor protection rules, and are subject to a specific (and favourable) tax treatment under the Inland Revenue Ordinance (IRO) following amendments introduced as part of the 2021 Fund Tax Exemption Regime. This article explains the key features of carried interest and performance fee arrangements, the structuring options available to fund managers, the Hong Kong tax treatment, and the regulatory requirements that apply.

Carried Interest in Private Equity and Venture Capital Funds

In a typical private equity fund, the fund manager (acting through a general partner entity) receives a carried interest—usually 20% of net profits—as compensation for its investment management activities. The carried interest is typically subject to a preferred return (hurdle rate), which ensures that limited partners (investors) receive a specified minimum return on their capital before the general partner begins to participate in profits.

The mechanics of a standard carried interest structure are as follows. First, all distributed proceeds are returned to limited partners until they have received back 100% of their invested capital and the preferred return (typically 8% per annum, compounded). Second, a "catch-up" provision allows the general partner to receive 100% of distributions until it has received an amount equal to 20% of total profits (or such other percentage as agreed). Third, all remaining distributions are split 80/20 between limited partners and the general partner as carried interest. This structure ensures that the general partner's economic interest is fully aligned with that of the investors: the manager only earns carry after investors have been made whole and received their preferred return.

Clawback provisions are an essential investor protection mechanism in carried interest structures. They require the general partner to return previously distributed carry if, at the end of the fund's life, the general partner has received more carry than its share of net profits (for example, because early profitable investments were realised before later loss-making investments). Clawback provisions may be triggered at the end of the fund, at specified interim dates, or both. Fund managers should ensure that carry recipients are able to meet any clawback obligation, which may require escrow arrangements or provisions requiring carry recipients to retain a portion of distributions.

Performance Fees in Hedge Funds

In hedge funds and other open-ended liquid investment funds, performance fees are calculated periodically—typically quarterly or annually—based on the fund's investment returns during the relevant period. The standard performance fee structure involves: a performance fee rate (typically 20% of net profits, though rates vary); a high-water mark, which ensures that the manager only earns performance fees on returns that exceed the fund's previous peak NAV per share, preventing the manager from earning fees on the same gains twice; and in some funds, a hurdle rate, which requires the fund to achieve a minimum return before any performance fee is charged.

The high-water mark is the most important investor protection mechanism in hedge fund performance fee structures. It works as follows: if the fund's NAV per share falls below its previous high point (the high-water mark), no performance fee is charged until the NAV recovers above the high-water mark. This ensures that investors do not pay performance fees during a recovery period following a loss, since they are not receiving "new" profits but are simply regaining ground lost in a prior period.

Some funds use a modified high-water mark with a "loss carryforward" or "crystallisation" approach, under which the high-water mark is reset periodically (for example, annually). Investors should be aware of the crystallisation mechanism in their fund, as it determines when and how frequently performance fees are calculated and locked in. Monthly or quarterly crystallisation means that performance fees on profitable periods may be locked in before losses in later periods can offset them, potentially resulting in the investor paying performance fees even in years where their overall return is negative.

Structuring Carried Interest in Hong Kong

In Hong Kong-based funds, carried interest is typically structured through a general partner entity—usually a limited partnership or a limited liability partnership—that holds the carry interest in the fund. The carry may be allocated to the general partner itself, which then distributes it to individual carry recipients (the fund's investment professionals), or the carry may be directly allocated to individual carry recipients through a co-investment or profit participation arrangement.

For Limited Partnership Fund (LPF) structures governed by Hong Kong law, the carried interest provisions are set out in the limited partnership agreement (LPA). The LPA specifies the amount of carry, the hurdle rate, the catch-up mechanism, the distribution waterfall, the vesting schedule for individual carry recipients, and the clawback provisions. Careful drafting of these provisions is essential to avoid disputes between the general partner, individual carry recipients, and limited partners.

For Cayman Islands-domiciled funds with Hong Kong-based managers, the carried interest structure is typically set out in the Cayman limited partnership agreement, with separate arrangements (such as a side letter or carry plan) governing the allocation of carry among the manager's investment professionals in Hong Kong. The interaction between the Cayman LP structure and Hong Kong employment or service arrangements for carry recipients should be reviewed carefully from both a legal and tax perspective.

Hong Kong Tax Treatment of Carried Interest

The tax treatment of carried interest in Hong Kong was significantly improved by amendments to the Inland Revenue Ordinance (IRO) introduced as part of the 2021 Fund Tax Exemption Regime enhancements. Under the current Hong Kong regime, qualifying carried interest received by a fund manager or its employees from a qualifying fund is subject to a concessionary profits tax rate of 0% (for corporations) or a concessionary salaries tax rate of 0% for individuals.

To qualify for the concessionary tax treatment, the following conditions must be met: the carried interest must be received from a qualified fund (an investment fund that meets specified criteria relating to its structure, investor base, and activities); the fund must be managed by a person carrying on a business in Hong Kong; the carried interest must be attributable to qualifying investments (investments in private companies, real estate, infrastructure, and certain other qualifying assets); and the fund manager or carry recipient must meet certain eligibility conditions.

This concessionary treatment makes Hong Kong highly competitive with other fund jurisdictions, including Singapore, which has introduced similar carry incentive schemes. Fund managers considering establishing or relocating their operations to Hong Kong should seek detailed tax advice on whether their carry arrangements qualify for the concessionary treatment and what conditions must be satisfied.

For performance fees in hedge funds—as distinct from private equity carried interest—the tax treatment depends on the nature and structure of the arrangement. Performance fees received by a Hong Kong-licensed fund manager in the course of carrying on a business are generally subject to profits tax at the standard corporate rate. Performance fees allocated directly to individual fund managers as part of their employment compensation are subject to salaries tax. The distinction between carry and performance fees—and the applicable tax treatment—requires careful analysis in each case.

Regulatory Requirements for Performance Fee Disclosure

The SFC's regulatory framework for fund managers imposes disclosure and transparency requirements in relation to performance fees. Under the Fund Manager Code of Conduct and the Code on Unit Trusts and Mutual Funds, fund managers must: clearly disclose the performance fee rate, the calculation methodology, and the high-water mark provisions in the fund's offering documents; ensure that performance fees are calculated and charged in accordance with the offering documents; not impose performance fees that are not disclosed to investors; and treat performance fees as a cost borne by the fund (not the manager) for the purposes of fund accounting.

Where a fund has multiple share classes with different performance fee structures, the offering documents must clearly explain how performance fees are allocated among classes. Cross-class subsidisation of performance fees—where one class of investors effectively subsidises the performance fee payable by another class—is not permitted.

For SFC-authorised retail funds, the SFC imposes additional restrictions on performance fee structures, including limits on the frequency of crystallisation and requirements for a minimum observation period. Fund managers should confirm the applicable requirements with the SFC before launching a retail fund with a performance fee.

Vesting of Carried Interest and Employment Arrangements

In most fund management businesses, individual carry recipients—typically the investment team and senior management—are allocated carry as part of their overall compensation package. The carry is usually subject to a vesting schedule that requires the individual to remain with the manager for a specified period (typically four years) before the carry vests fully. If the individual leaves before full vesting, unvested carry is forfeited.

In Hong Kong, the vesting of carry and the treatment of forfeited or clawed-back carry on departure give rise to employment law, contract law, and tax questions that should be addressed in the individual's employment agreement or carry plan. Fund managers should ensure that their carry plan documentation clearly addresses the vesting schedule, the treatment of carry on termination (whether voluntary or involuntary), the clawback mechanics, and the tax gross-up (if any) for clawback amounts.

Conclusion

Carried interest and performance fee structures are fundamental to the economics of investment fund management in Hong Kong. Their design requires careful attention to investor alignment, regulatory compliance, tax efficiency, and employment law considerations. Hong Kong's concessionary tax treatment of qualifying carried interest makes it an increasingly attractive jurisdiction for private equity and venture capital fund managers, while the SFC's regulatory framework ensures that performance fee arrangements are transparent and fair to investors.

Alan Wong LLP's Investment Funds practice advises fund managers on the design, structuring, and documentation of carried interest and performance fee arrangements, including limited partnership agreement drafting, carry plan design, regulatory disclosure compliance, and interaction with the Hong Kong Fund Tax Exemption Regime. Contact us to discuss your carried interest or performance fee structuring needs.