Carried interest is a performance-based compensation mechanism where fund managers receive a percentage of investment profits above a predetermined threshold. This structure aligns manager incentives with investor returns and serves as the primary profit-sharing component in private equity, venture capital, and hedge funds.
What is Carried Interest
Carried interest represents the manager's share of profits generated from successful investments. Unlike management fees that provide steady operational income, carry creates direct alignment between fund managers and investors by tying compensation to actual returns. The term originated from shipping practices where ship captains received a "carried interest" in cargo profits.
Fund managers earn carry only after returning invested capital plus achieving minimum return thresholds. This structure ensures managers focus on generating superior returns rather than simply collecting fees. The carry mechanism transforms fund managers into economic partners who share both risks and rewards of investment performance.
Most private equity and venture capital funds use the standard 20% carry rate, though this can vary based on fund strategy, track record, and market conditions. First-time fund managers may accept 15% carry, while top-tier firms occasionally negotiate 25-30% for specialized strategies. The carry percentage directly impacts the economic split between general partners (GPs) and limited partners (LPs).
Carried Interest Structure and Key Terms
The carried interest structure involves multiple contractual terms that define when and how managers receive profit distributions. These terms establish the economic waterfall that governs cash flow distribution between LPs and GPs.
Carry Percentage
The carry percentage determines what share of profits above the hurdle rate flows to fund managers. Standard market terms have converged on 20% carry as the industry norm. First-time funds may offer 15%, while top performers command 25-30%. Some funds implement tiered carry structures where the percentage increases with performance, such as 15% on returns of 8-12% and 20% on higher returns.
Hurdle Rate
The hurdle rate protects LP interests by ensuring managers only receive performance fees after delivering meaningful returns. Standard private equity funds use 8% hurdle rates, though venture capital funds may have lower hurdles (6-7%) and real estate funds might use 6-9% depending on leverage and asset type.
The catch-up provision allows GPs to receive a disproportionate share of distributions after the hurdle is met until they've received their full carry percentage on all profits. With a 20% carry and catch-up provisions, GPs receive 100% of profits immediately after the hurdle until they've caught up to 20% of total profits.
Clawback Provisions
Clawback provisions ensure GPs only retain carry earned on actual fund-level profits. If a fund distributes carry based on early successful exits but later investments fail, the GP must return excess distributions. Most funds require GPs to hold 20-30% of carried interest distributions in escrow during the investment period as a buffer.
Calculation Methods: European vs American Waterfall
Two primary approaches calculate carried interest, significantly impacting economics between LPs and GPs.
European Waterfall (Whole-Fund Method): GPs only receive carried interest after the entire fund achieves the hurdle rate. This ensures managers don't receive carry on early winners if later investments underperform—the most LP-friendly approach.
American Waterfall (Deal-by-Deal Method): Carried interest calculates on each investment separately. GPs receive carry on individual profitable deals regardless of overall fund performance. This front-loads GP economics 3-7 years earlier than European waterfalls.
| Feature | European Waterfall | American Waterfall |
|---|---|---|
| Basis | Whole fund | Deal-by-deal |
| GP Timing | Later | Earlier |
| LP Protection | Stronger | Weaker |
Carried Interest Applications Across Industries
Carried interest structures extend across multiple alternative investment industries, each adapting the basic framework to specific asset class characteristics.
Private Equity Buyout Funds pioneered the carried interest model for leveraged buyout funds, which invest in mature companies, implement operational improvements, and exit after 4-7 years. The standard 20% carry and 8% hurdle rate became the industry norm.
Venture Capital Funds use identical carry structures despite dramatically different risk profiles. VC managers invest in early-stage companies with high failure rates but potential for outsized returns. The power law distribution of VC returns (where a few big winners drive all returns) makes carry particularly valuable for successful GPs.
Hedge Funds typically charge the "2 and 20" fee structure - 2% management fees plus 20% performance fees. Unlike private equity, hedge funds often have no hurdle rate or use low hurdles (0-6%). The high water mark provision replaces the long-term clawback mechanism since investors can redeem capital quarterly or annually.
Tax Treatment and Controversy
The tax treatment of carried interest has generated substantial policy debate and legislative attention. Current U.S. tax law treats most carried interest as long-term capital gains taxed at preferential rates (20% federal plus 3.8% net investment income tax) rather than ordinary income rates (up to 37% federal).
The 2017 Tax Cuts and Jobs Act implemented a three-year holding period requirement. Investments held more than three years qualify for long-term capital gains treatment (20%), while shorter holding periods result in ordinary income taxation (up to 37%).
Proponents argue carried interest represents entrepreneurial compensation for building businesses and creating value. Fund managers invest their own capital (1-3% of fund size) and take on investment risk alongside LPs.
Critics characterize it as compensation for services that should face ordinary income taxation, similar to executive bonuses. Eliminating capital gains treatment could generate $14-18 billion in additional tax revenue over 10 years according to policy estimates.
Carried Interest vs Management Fees
Fund manager compensation combines two distinct components with different economic characteristics: management fees and carried interest.
| Component | Management Fees | Carried Interest |
|---|---|---|
| Purpose | Cover operating expenses | Performance-based profit sharing |
| Calculation | Percentage of committed capital | Percentage of profits above hurdle |
| Typical Rate | 1.5-2% annually | 20% of profits |
| Payment Timing | Quarterly/annual | At investment exits |
| Alignment | Weak (paid regardless) | Strong (tied to returns) |
Management fees (1.5-2% of committed capital annually) cover operational expenses including salaries, deal sourcing, and portfolio monitoring. A $500M fund charging 2% generates $10M yearly revenue. This covers operating budgets but typically doesn't provide substantial partner profits.
The traditional "2 and 20" fee structure (2% management fees and 20% carried interest) emerged as the industry standard. However, fee compression has pushed many funds toward 1.5% management fees or lower, particularly for larger funds.
Frequently Asked Questions
What is carried interest in simple terms?
Carried interest is a performance bonus where investment fund managers receive a share of profits (typically 20%) after returning investor capital and achieving minimum return targets. Think of it as profit-sharing that only kicks in when the fund succeeds.
How much carried interest do fund managers receive?
Fund managers typically receive 20% of profits above the hurdle rate. First-time managers may accept 15%, while top-tier firms negotiate 25-30%.
What is the difference between management fees and carried interest?
Management fees (1.5-2% annually) provide steady operational income regardless of performance, while carried interest creates performance-based upside. Fees cover firm expenses, while carry represents the primary wealth creation mechanism.
Do fund managers pay capital gains tax on carried interest?
Yes, carried interest receives long-term capital gains tax treatment (20% federal) when underlying investments are held for more than three years. Shorter holding periods result in ordinary income taxation (up to 37%).
Key Takeaway
Carried interest represents the primary economic incentive aligning fund managers with investor returns. Understanding the carry structure—including percentage rates, hurdle thresholds, waterfall methodology, and clawback provisions—is essential for evaluating fund economics and manager alignment. As tax policy continues evolving around this compensation model, carried interest remains central to how private equity, venture capital, and hedge fund managers build wealth.