An End to Wall Street’s Greatest Loophole?

An End to Wall Street’s Greatest Loophole?

An impending tax change could affect the sought-after private equity industry.

(Wall Street’s Charging Bull statute. | SOURCE: Investopedia)

Amid all the issues and controversies engulfing the Trump administration, the compensation of private equity and venture capital executives is not a headline for any newspaper. But for executives at Wall Street’s premier firms, the best-kept secret is seemingly under siege, after spending the better part of the last two decades lurking in the shadows.

The secret in question is carried interest, which is the share of profits that executives at investment firms receive for strong financial performance. Carried interest is a share of the profits that investment firm executives receive if their funds perform well. Despite being marketed as a performance incentive, critics of carried interest argue that it functions like a bonus, while being taxed like an investment.

Now, before we explore these issues further, let’s take a step back and define some key terms.

There are many key players in the world of alternative asset managers — the name given to non-traditional investment firms that invest outside of the traditional assets (such as stocks, bonds, and cash). These firms include private equity firms (like Blackstone, The Carlyle Group and Apollo), venture capital firms (like Andreessen Horowitz and Sequoia Capital), growth equity firms, hedge funds (like Citadel, Elliott and Bridgewater), real estate, private credit and others.

Alternative asset managers raise “funds,” which pool capital from multiple investors and are used to make long-term investments in private companies. These investors become limited partners (LPs) in the fund. They are obligated to deliver the money to the investment manager when the investment manager decides to deploy capital — a process known as a “capital call.” The general partner (GP) is the firm itself, which typically performs a small coinvestment, often around 5% of the firm’s total capital.

These funds typically have a lifespan of around 10 years, allowing sufficient time to search for, acquire, improve, and sell the companies. While the strategies employed by alternative asset managers differ, their goal is the same: to generate a return on investment.

For LPs, investing in a private equity fund is similar to how everyday investors put money into the stock market, as both aim to generate long-term gains. They aim to generate a return on invested capital (ROIC) to support pensioners, secure additional funding and resources for institutions, or generate more income for the investors themselves.

Consider the following scenario: the investment firm John Doe raised a new, flagship $10 billion investment fund (Fund X) in 2023. In 2025, they began buying up companies in the hopes of selling them for future gains.

(Fictional John Doe Investment Firm Fund X. | SOURCE: Google Gemini)

At this point, John Doe is unable to recognize any returns on Fund X. If we assume all $10 billion in assets have been deployed (invested), then the entirety of the fund is tied up in highly illiquid assets (as it is tough to quickly sell a company and convert its value into cash). But the private equity firm still needs to proverbially “keep the lights on,” to pay its employees and other necessary expenses.

The result is the “two and twenty” fee structure that private equity firms have long used. The “two” is a two percent management fee, which means that the private equity firm collects a fee of two percent of the total assets under management (AUM) to cover operating expenses, salaries, research, technology, and administrative costs, among other expenses. This structure seems reasonable until you realize that Blackstone, the largest alternative asset manager, has an AUM of over $1 trillion, meaning that it charges its LPs $20 billion a year for simply investing their money.

But the real money is the “twenty,” a 20 percent performance fee. At the end of a fund’s life, LPs want their return on investment, and the GPs want a return on their invested equity. In the scenario, the LPs would receive a preferred return, enabling them to recover their original $10 billion, as they are the ones who assumed the risk by investing their capital with John Doe. 

Most funds have an eight percent “hurdle rate,” meaning they must achieve at least an eight percent annualized return for investors (LPs) before the GPs get their profit share. After the eight percent threshold, the profits are split, with LPs receiving 80 percent and GPs receiving 20 percent.

Now, assume Fund X has generated a 13 percent internal rate of return (IRR) by the end of its life ($13 billion in total proceeds on the original $10 billion investment). The LPs get their $10 billion back first, plus 80 percent of the $3 billion in profits ($2.4 billion), while the GP receives the remaining 20 percent  — $600 million in carried interest. Additionally, the GP collected a two percent annual management fee on the $10 billion fund over six years of active management, amounting to approximately $1.2 billion. That’s $1.8 billion in total revenue to the firm from just one fund — excluding any investment gains from the GP’s committed capital.

Because carried interest depends entirely on fund performance, poorly performing funds may generate no carry at all, while strong-performing ones can deliver extraordinary payouts. The $600 million in carry is typically distributed across the firm's employees based on a predetermined formula — usually tied to seniority. In many firms, senior partners may receive 60% or more of the carry pool, which in this case would mean roughly $360 million split among just a handful of individuals.

Thus far, we have imagined a simplified world — one where the private equity firm has only one fund. However, if funds begin compounding — that is, the private equity firm starts raising new funds during the life of existing funds — the money pours in with strong fund performance. 

At prominent firms, senior partners can easily clear $50 million a year in total compensation. At the highest tax brackets, income is taxed at a federal rate of 37 percent. Carried interest, however, is classified as “capital gains” and is taxed at only 20 percent, meaning that partners at these firms retain an additional 17 percent of their income at the federal level.

However, “capital gains” typically refers to investments where an individual has invested personal capital (such as a stock, bond, or other asset in which personal assets were invested and a return was recognized). Many private equity employees did not risk anything to get carried interest. They just showed up each day, did their job, and collected their carried interest when the fund closed.

And this is the crux of the issue: some of the wealthiest people in America, most of whom are multi-millionaires and some who are billionaires, are not paying “their fair share,” paying an abnormally low tax rate for an amount of income that would make an average American’s eyes water.

This so-called “carried interest loophole” has long been scrutinized, but President Trump finds himself in somewhat of a pickle when it comes to pleasing both parties.

President Trump has claimed that he will do away with the loophole and make carried interest taxable at the appropriate 37% rate. But many of the people in Trump’s inner circle might feel otherwise.

Take Marc Andreessen, one of the founders of the highly successful venture capital firm Andreessen Horowitz. This change would cause Andreessen and everyone else at Andreessen Horowitz (commonly known as a16z) who receives carried interest to be taxed at a higher tax rate. To them, this minimizes their incentive to do their job and lowers the incentives for the “best and the brightest” to work for their firms.

Two other prominent examples: Marc Rowan, CEO of Apollo Global Management, and Stephen Schwarzman, CEO and founder of Blackstone. Rowan, who is in President Trump’s orbit and received interest for secretary of the treasury, has publicly criticized the overregulation of markets and has expressed viewpoints in favor of low tax rates, making him a likely proponent of maintaining the status quo. Schwarzman has been a close ally of Trump and has a substantial personal stake in maintaining the current tax structure. Schwarzman has defended the private equity industry against proposed regulatory changes in the past and is likely to continue doing so.

The future of the carried interest loophole, locked in this struggle, remains uncertain. In July 2025, President Trump signed the One Big Beautiful Bill Act, a sweeping tax and spending package that left the carried interest tax preference intact. Despite renewed attention to the issue, the loophole remains open — for now.

(President Trump after signing the One Big Beautiful Bill Act into law. | SOURCE: Samuel Corum / Getty Images)

Putting the merits and ethics of private equity aside, this change would be a significant shift in the incentive for engaging in private equity in the first place.

The real money is made based on the overall firm's performance. If that money is slashed, pursuing a career in private equity might not be as appealing as it once was — including for the many W&L students who want to make a lateral move from investment banking.

Private equity is a brutal industry, with demanding hours, minimal work-life balance, and a cutthroat culture of type-A people. While the base and bonus compensation are lucrative, reducing take-home carry interest will minimize the appeal of enduring the equivalent of “finance hazing” in hopes of eventually making it big.

And it’s worth noting that carried interest does not apply only in private equity; venture capital, growth equity, hedge funds, private credit, and other areas of finance also rely on the loophole. The reality is that for many students at W&L, the luster of jobs in the alternative asset space may begin to fade very shortly, or, if not under Trump, certainly under the next Democratic administration.

So instead of unthinkingly following the herd toward private equity in pursuit of money, W&L students should ask themselves what they truly want to do — and whether the incentive structure of modern finance still aligns with it.

The opinions expressed in this magazine are the authors’ own and do not reflect the official policy or position of The Spectator, or any students or other contributors associated with the magazine. It is the intention of The Spectator to promote student thought and civil discourse, and it is our hope to maintain that civility in all discussions.