Carried Interest
Carried interest is the share of a fund's profits — typically 20% — allocated to the general partner as performance compensation once the limited partners have recovered their invested capital and earned a minimum hurdle rate return, aligning the GP's economic incentives with LP performance.
Key takeaways
- The standard private equity carry structure is '2 and 20': 2% annual management fee on committed capital plus 20% carried interest on profits above the hurdle rate.
- Most PE funds include an 8% preferred return (hurdle rate) before carry vests; once the hurdle is cleared, a catch-up provision allows the GP to receive 100% of distributions until the 80/20 split is achieved.
- Carried interest is subject to favorable capital gains tax treatment in the U.S. (as long-term capital gains if the holding period exceeds three years), a politically contentious issue.
- Clawback provisions obligate GPs to return carry previously received if later fund losses reduce total LP returns below the hurdle rate.
- GP co-investment (the GP commitment, typically 1-5% of committed capital) ensures the GP shares downside risk alongside LPs.
Explanation
Carried interest (or 'carry') is the defining feature of private equity, venture capital, and hedge fund compensation structures, representing the GP's share of investment profits after LPs achieve a minimum return. The term originates from historical shipping partnerships where the cargo captain (general partner) received a share of the cargo's value ('interest in the carried cargo') as compensation for bearing the risk and management of the voyage.
The mechanics of a standard waterfall structure work as follows: distributions flow first to LPs as return of capital until all contributed capital is returned; then to LPs as preferred return (hurdle) until the hurdle rate (typically 8% per annum, compounded) is achieved; then to the GP as a catch-up until the GP has received 20% of all profits above the hurdle; then 80/20 between LPs and GP thereafter. This structure ensures LPs are fully protected before the GP shares in economics, aligning incentives.
The hurdle rate and catch-up mechanics interact in important ways. Consider a fund with $100 million in LP capital. The fund returns $200 million total. After return of capital ($100M), there are $100M in profits. The LP preferred return on $100M for five years at 8% is approximately $47M. This means the first $47M of profits go to LPs as preferred return. The GP catch-up then receives $11.75M (20% ÷ 80% × $47M) until the 80/20 split is achieved. The remaining $100M − $47M − $11.75M = $41.25M is split 80/20 ($33M to LPs, $8.25M to GP). Total GP carry is $11.75M + $8.25M = $20M, exactly 20% of the $100M total profit.
Carried interest taxation is one of private equity's most controversial topics. In the U.S., carry received by individual partners is taxed at long-term capital gains rates (20% + 3.8% NIIT for high earners) rather than ordinary income rates (up to 37%), provided the underlying fund investments are held for more than three years under the Tax Cuts and Jobs Act (2017) extension from one year. Critics argue this is preferential treatment for what is effectively compensation income; the industry argues it reflects the inherent capital risk taken by GPs through their co-investment.
Clawback provisions are critical LP protections. Because carry is typically distributed on a deal-by-deal basis as investments are realized, early profitable exits can result in carry being paid before the full fund has performed. If subsequent investments generate losses, LPs may have received less than their full preferred return, obligating the GP to return ('clawback') previously received carry. European waterfall structures (fund-level rather than deal-by-deal) avoid this issue by calculating carry only on the full fund's performance.
Formula
GP Carry = (Total Profits above Hurdle) × Carry Percentage; Hurdle Amount = Contributed Capital × ((1 + Hurdle Rate)^Years − 1)
Example
A buyout fund raises $500 million in LP commitments and invests in eight companies over five years. After ten years, the fund has returned $1.05 billion to LPs. The calculation: LPs receive $500M (return of capital) + $500M × (1.08^7 − 1) ≈ $856M − $500M = $356M in preferred return. Actually computing: $500M × (1.08^5) ≈ $734M total preferred return = $234M profit. After the 8% preferred return, the GP catch-up provision (assuming 100% catch-up) allocates 100% of the next distribution to the GP until the GP has received 20% of all profits above the hurdle. Total LP profits above hurdle = $1,050M − $500M − $234M = $316M. GP carry = $316M × 20% = $63.2M. This represents the GP's carried interest, subject to clawback if losses emerge from unrealized positions.
Related terms
Basis Buyout Fund Clawback Co Investment Custodian Equity General Partner Gp Commitment Hedge Fund Hurdle Rate Invested Capital Irr Internal Rate Of Return