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Carried Interest Is A Hidden Gem

I now pay considerably more attention to the tax implications of my investment decisions. Gone are the days where I looked forward to receiving dividend income.

Our circumstances may differ, and therefore, my decision to significantly reduce dividend income may not align with your objectives. Furthermore, the tax treatments of different forms of investment income differ from one country to another. I, therefore, caution you that I do not know your circumstances and do not provide individualized advice or recommendations.

One of my objectives is to generate attractive long-term total investment returns. Taxes have an astonishing way of destroying wealth, and therefore, I endeavor to keep as much as legally possible out Canada Revenue Agency's hands. Active trading and the receipt of dividend income do not aid me in this regard.

This brings me to the point of investing in great asset managers. Companies such as Blackstone (BX), Brookfield Asset Management (BAM), and Brookfield Corporation (BN) have carried interest as a hidden gem that conventional companies do not have. They can defer, often for several years, their tax obligations.

In my recent Think Like An Owner When Investing post, I include an excerpt from Bruce Flatt's (CEO of Brookfield Corporation) February 13, 2025 Letter To Shareholders. I now reflect another excerpt from this letter that explains carried interest and why it is a hidden gem.

Carried Interest Is Our Hidden Gem

Our carried interest is a large asset—and is not well understood by most investors. It is, however, of immense value and is our hidden gem sitting in plain sight. We estimate the value of our carried interest at ±$30 billion. To emphasize how solid this estimate is, over the next 10 years alone, as we sell businesses for our clients, we should generate ±$20 billion of cash flow from carried interest to Brookfield Corporation in the form of our share of the cash generated. Given this scale, we thought it worthwhile to lay out for you how carried interest works and how it contributes to our cash flows and, in turn, the value of our business.

Alignment Is Critical to Our Business

Our asset management business raises capital from pension plans, sovereigns, financial institutions, and private retail investors around the world with the objective of investing that capital in great assets and businesses in order to generate attractive risk-adjusted returns for them. To align our interests, we are a significant investor alongside our clients as a side-by-side partner. Further alignment is also created by us sharing in the returns or profits generated for clients above a prescribed level. This share of the profits is called carried interest.

Put simply, carried interest is our share of the profits realized on an entire fund, subject to that fund exceeding a minimum target return for clients. If we meet fund expectations, we get 20% of the profits. If we earn nothing for our investors, we get nothing.

Investing Is the Lifeblood of Asset Management

The lifecycle of carried interest starts with the raising of client capital for a dedicated strategy. With the growth of our asset management franchise over the years, we now manage $240 billion of capital that is eligible to earn carried interest. This figure has increased at an annual rate of 15% over the past five years, and we expect that to continue to scale significantly going forward.

The second step is the deployment of the capital. We have established an investment track record of delivering strong returns over a long period of time, with almost all our funds meeting or exceeding their target returns. Much of our outsized returns are generated from our deep operating capabilities and as we implement our business plans, our carried interest accrues and compounds alongside the cash flow generation and value creation. The longer we have the capital working for us, the more the returns compound and in turn, so does the carried interest potential.

The last step is monetization. Selling an investment is what crystalizes a large component of the profit of an investment. As assets and businesses are sold, capital is returned to clients. Once all the original invested capital, plus a minimum compound return on drawn capital, has been returned to clients we start to share in the entirety of the profits. To be clear, carried interest is only triggered with realized cash transactions; the valuations used prior to sale have no impact on carried interest, period.

We adopt a conservative approach to the recognition of carried interest in our financial statements. We wait for the invested capital of the entire fund (as opposed to individual deals) to be returned to clients, the passing of the minimum compound return, and the comfort that there is remote risk of claw-back before recording carried interest in our earnings. This conservative approach, which creates further alignment with our clients, delays the recognition towards the end of a fund’s lifecycle but leads to a larger contribution when recognized.

Therefore, much of the value creation in our investments, reflected through carrying value increases or from early monetizations in a fund, has yet to be recognized in our earnings. Today we have accumulated $11.5 billion of carried interest, or $7 billion net of costs, most of which we expect to recognize into our earnings over the next five years.

The key to the value of carried interest is creating value in businesses and selling assets opportunistically at attractive values to deliver good returns to our clients. Fortunately, demand for our assets and businesses remains strong, as we own assets and businesses that form the backbone of the global economy underpinned by stable, long-dated, largely contracted or regulated cash flows. The breadth of our fund offerings has enabled us to continue to transact through economic cycles. In 2024, we monetized close to $40 billion of assets and as transaction activity picks up, we expect to be actively monetizing investments.

Carried Interest Generates Substantial “Real” Cash

The outlook for carried interest is significant. If we successfully execute our plans in our asset management business, we expect to receive ±$20 billion in cash directly paid to the Corporation over the next 10 years. These cash flows will come predominantly from funds that already exist today.

Further, the growth in size of each progressive vintage of funds, combined with the scale of our monetizations, should lead to even greater and more recurring carried interest over the longer term—well above our historical levels. This significant amount of incremental cash flow will allow us to deliver further value for you by either reinvesting back into the business or returning capital via opportunistically repurchasing our shares.

We believe that the value of our carried interest is ±$30 billion, which amounts to $21 per share. This reflects what we would earn in cash today by selling assets in our funds at fair value, plus the value of the carried interest potential valued using a conservative market multiple. Notwithstanding the numbers being very large, the carried interest often remains underappreciated. Nevertheless, it is our hidden gem in plain sight.

Final Thoughts

Taxes have an astonishing way of destroying wealth. The tax implications of an investment, however, is not my sole consideration. I must consider my risk tolerance.

I am at a life stage where I am employing a Registered Retirement Savings Plan (RRSP) meltdown strategy for my wife/me; RRSPs must be converted to a Registered Retirement Income Fund (RRIF) by the end of the year in which we turn 71. Unless we significantly reduce the value of our RRSPs prior to conversion, the minimum annual RRIF withdrawals will place us in the highest personal income tax bracket.

I have holdings that distribute a dividend but this form of capital allocation should not be a priority. I, therefore, have zero interest in Real Estate Investment Trusts (REITs). My preference is to invest in companies that retain earnings and cash flow to generate attractive rates of return and/or repurchase attractively valued shares.

BX, BAM, and BN have quarterly distributions but carried interest is their hidden gem that appeals to me. They can defer distributions for years! Furthermore, in most cases, carried interest is a return on investment that is taxed as a capital gain rather than ordinary income (usually at a lower rate).

Depending on your circumstances, you may wish to assess whether these are companies that may aid you on your journey to financial freedom.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.