A partner in a private equity or venture fund expects $10M of carried interest over the next ten years. The partner lives in California or New York and holds $5M of liquid capital in index funds. Exhibit 1 compares leaving that capital where it is against running a tax-aware long/short program on it, at four levels of intensity. A taxable limited partner expecting $10M of distributions from the same fund is in the same position.
| Index funds | 150/50 | 200/100 | 250/150 | 300/200 | |
|---|---|---|---|---|---|
| Tracking error to the benchmark | none | 2% | 4% | 6% | 8% |
| Net realized losses, year one | $0 | $1.05M | $1.75M | $2.45M | $3.15M |
| Cumulative losses by year five | $0 | $3.7M | $6.1M | $8.5M | $11.0M |
| Cumulative losses by year ten | $0 | $6.2M | $10.5M | $14.4M | $18.7M |
| Carry sheltered, of $10M | $0 | $5.2M | $8.8M | $10.0M | $10.0M |
| Tax deferred at 37% | $0 | $1.9M | $3.2M | $3.7M | $3.7M |
| Tax paid as the carry arrives | $3.7M | $1.8M | $0.45M | $0 | $0 |
Why private equity gains are plannable
A fund runs on a ten-year clock. A VP, principal, or partner with points generally knows when carry should begin distributing. By the middle of the fund’s life they usually have a reasonable range for the amount. Most large capital gains do not behave this way. A company sale can come together in months. A stock can appreciate unexpectedly. Carry is the rare tax event a person can see half a decade out.
The same clock runs on the limited partner side. A taxable investor in the fund receives distributions as the portfolio companies exit, mostly in the second half of the fund’s life, and the gains are visible in advance for the same reason. A family office or individual with commitments across several vintages can usually estimate the distributions arriving over the next few years with reasonable confidence. This essay is written around carry because the gain is most concentrated there, but the mechanics apply to any large, foreseeable private equity gain.
The usual approach is to think about the tax when the distribution notice arrives. By then the outcome is fixed. A partner in a high-tax state gives up roughly 37% of each distribution. On $10M that is $3.7M. The size of the bill is one problem. The years of notice that went unused are the larger one, since the tools that can reduce the tax need several years to work.
What the strategy is
A tax-aware long/short portfolio is long the stocks a quantitative model rates attractive and short the names it rates weakest. A 200/100 portfolio holds $200 long and $100 short for every $100 of capital, so net market exposure stays at 100%.4 The return the extension pursues comes from the spread between the stocks the model favors and the ones it does not, rather than from the direction of the market.5
In a rising market some of the shorts lose. In a falling market some of the longs do. Positions will go up or down for idiosyncratic reasons as well (their stock-specific risk). The portfolio realizes those losses as they appear and holds the winners. Because the book is levered and turns over, the losses do not run out the way they do in a direct-indexing account, which harvests a static pool of lots and slows down after a few years.6
Capital losses carry forward indefinitely. They accumulate into a loss base that offsets capital gains from any source, in any year, including carry.
Why it fits a private markets investor
The first reason is the loss base. A principal expecting meaningful carry from a fund now in its third or fourth year has perhaps three to six years of runway. A program started today and sized against the expected distributions may accumulate enough losses to cover most or all of them. The intensity can be adjusted as the timing firms up. It can run harder as the distributions approach and ease off after they land. The same base serves Fund II carry, co-investment gains, a secondary sale of GP stakes, and eventually Fund III.
The second reason is usually invisible, and it may be the larger of the two. A mid-career private markets professional typically holds unrealized carry, a GP commitment, co-investments, deferred compensation tied to firm economics, and current income that depends on fundraising. Every one of those is a levered claim on equity markets. Private marks smooth the reported returns. But as Cliff Asness has argued for years, volatility that low reflects the appraisal process rather than the underlying risk.7 A serious equity drawdown hits portfolio marks, exit windows, fundraising, carry expectations, and compensation at the same time. Liquid wealth held in index funds adds more of the same exposure under a different label.
The long/short extension has little correlation to any of that. Its return depends on the model’s stock selection rather than on whether markets rise. So the program may do two jobs at once. It builds the loss base that absorbs carry as it arrives, and it may add a return stream that behaves differently from everything else the professional owns.
The case study, year by year
Take the 200/100 column of Exhibit 1, the middle setting. The program starts on $5M in year one and realizes about $1.75M of net losses. The rate declines toward a long-run pace of roughly 17% of the program a year, so by the end of year three the loss base stands near $4.2M with no carry yet received.
Distributions begin in year four at $2M a year. Each is offset in full for the first three years. By year seven the base has been drawn down to zero and the last two distributions are partly exposed. Across the whole $10M, $8.8M is sheltered and $3.2M of tax is deferred. The $0.45M that is paid comes due in years seven and eight.
The other columns show varying levels of leverage or “intensity”. At 150/50 the loss base covers about half the carry, and the program tracks the index within 2%. At 250/150 the base crosses $10M in year seven and every distribution is covered. At 300/200 it does so in year five, with unused losses left over for the next fund. Program size works the same way. At 200/100, a $2.5M program shelters about $4.4M of the $10M, and a $7.5M program shelters all of it.
Three main costs come with the strategy.
The first is tracking error. A 300/200 book can trail its benchmark by 8% in a bad year for the model, and the losses it realizes are genuine losses on the short side, paid for by gains on the long side. Higher settings harvest faster because they take more active risk. The second is fees and financing. A long/short program carries a management fee, financing on the short book, and trading costs that an index fund does not. Pre-tax, the strategy has to earn those back before the tax benefits add anything on top. Tax law’s economic substance doctrine requires a genuine investment purpose rather than just a strategy for tax benefits. The third is that the losses defer tax rather than remove it. The program’s basis falls by every dollar it harvests, and the embedded gain is taxed if the program is fully liquidated. Deferral over a long horizon has well-documented value on its own, and the gain can also be addressed through charitable gifts of appreciated lots or through the step-up in basis at death.8 The comparison is $3.7M paid now against $3.7M paid later, or possibly never, with the difference compounding in the meantime.
How a program is set up
The inputs are unusually knowable, so the sizing is straightforward.
Estimate the distributions. Use the fund’s actual pacing. The estimate covers which vintages are in carry, when the portfolio companies are likely to exit, and what the partner’s points imply in dollars. A range is fine. The program can be resized as the range narrows.
Choose the size and the setting. Exhibit 1 is the template. A $5M program at 200/100 covers most of a $10M expectation over a decade. A partner who wants full coverage sooner chooses a higher setting or a larger program, and accepts more tracking error. A partner who wants the base to keep working past the current fund chooses more capacity than the current fund needs.
Decide how the base is funded. The long/short book runs on top of an underlying portfolio, and that portfolio sets the market exposure. A base held in equities gives a beta near one. A base held half in Treasuries and half in equities gives a beta near 0.5, with the harvesting and the spread return working the same either way. For someone whose net worth is already a bet on equity markets, that allocation is worth setting deliberately rather than by default. Existing index holdings can often be transferred into the program rather than sold, which avoids realizing gains on the way in.
Adjust as the fund matures. The setting can be raised as distributions approach and lowered once the carry has been received, or shifted toward the next fund. Moving between settings is an adjustment rather than a liquidation.
The program requires liquid capital, a multi-year commitment, and tolerance for tracking error. It is run as a separately managed account, so the holdings, the losses, and the tax reporting are the investor’s own.
My view
The case for a private markets professional starts with the portfolio rather than the tax. Nearly everything they own already moves with equity markets. A tax-aware long/short program adds a return stream that depends on stock selection rather than market direction, and in my view the potential to diversify their total wealth that way is the first reason to run one. The tax is the second reason, and it sets the timing. Carry is taxed as a capital gain. It arrives on a schedule that can be estimated years in advance. Waiting until the distribution to consider any of this gives up the time the fund structure hands a partner for free. A loss base built during the quiet middle years of a fund is among the more productive uses of a private markets professional’s liquid capital. The arithmetic in Exhibit 1 is illustrative, but the shape of it holds under most assumptions I have tried. A program started three years before the first distribution arrives with a loss base already ahead of it.
For the mechanics and the research in full, see our full research primer. The founder’s tax problem makes the same lead-time argument for a different kind of liquidity event, our approach to tax-aware long/short describes the configurations, and the tax-aware long/short calculator uses the same loss schedule as Exhibit 1.