Carried interest ("carry") is the share of a private fund's profits — typically 20% — paid to the general partner as performance compensation, on top of the management fee, once the fund has returned invested capital and cleared any preferred return hurdle to limited partners.
Why It Matters
Carry is what aligns GP and LP incentives and is the primary way private equity, venture capital, and hedge fund principals actually get paid for performance rather than just asset gathering — the classic '2-and-20' structure (2% management fee, 20% carry) has defined the industry's economics for decades, even as fee compression has pushed some of those terms down.
How It Works in Practice
- 1LPs must first receive their invested capital back, plus (in most structures) a preferred return — commonly 8% annually — before the GP earns any carry
- 2Once the hurdle is cleared, the GP typically receives a 'catch-up' allocation, then splits remaining profits 80/20 with LPs
- 3European (whole-fund) waterfalls calculate carry only after the entire fund has returned capital and hurdle; American (deal-by-deal) waterfalls pay carry on each profitable deal as it exits, subject to clawback if later deals underperform
- 4Carry is typically taxed at long-term capital gains rates if underlying assets are held long enough — a persistent and politically contentious feature of the U.S. tax code
Common Pitfalls
Deal-by-deal waterfalls without a properly structured (and funded) clawback provision can leave a GP owing money back to LPs if early wins are followed by later losses — a real risk if the clawback isn't collateralized
The preferred return hurdle rate and whether it compounds materially changes the GP's actual earned carry — two funds both advertising '8% pref, 20% carry' can have very different effective economics depending on structure details
Carried interest's capital-gains tax treatment has been a repeated target of legislative reform proposals, creating real planning uncertainty for GPs