Carried Interest Explained Simply, With a Worked Example

Carried interest, usually just called "carry", is the share of a fund's profits paid to the fund manager. It's the main way private equity and venture capital managers get rich when they do well, and the main way their interests are aligned with their investors. It's also wrapped in jargon: hurdles, catch-ups, waterfalls and clawbacks. This guide unpacks all of it with simple numbers.

The basic idea

A private fund has two types of partners:

• Limited partners (LPs): the investors who provide most of the capital.
• The general partner (GP): the manager who runs the fund and makes investment decisions.

The GP earns money in two ways:

1. A management fee, commonly around 2% of committed capital per year during the investment period, often stepping down afterwards. This pays salaries and running costs.
2. Carried interest, commonly around 20% of the fund's profits. This is the performance reward.

That's the famous "2 and 20". Exact numbers vary. Some top venture firms charge 25% or 30% carry. Some larger buyout funds charge lower fees. Many first-time managers offer discounts.

Why it's called "carried interest"

The term is often traced back to medieval and early modern shipping, where captains received a share of the profits from the cargo they carried. Whatever its exact origin, the modern meaning is simply the manager's share of investment profits.

A simple example with no hurdle

In reality, LPs usually get back their capital including what was used for fees before carry is calculated. That makes fees part of the money LPs must recover first.

The hurdle rate (preferred return)

Many private equity funds include a hurdle, or preferred return, often 8% a year. The GP receives no carry until LPs have received their capital back plus that annual return.

Hurdles are common in buyout funds. They're less common in venture capital, where returns are so lumpy that a hurdle matters less and many top firms don't offer one.

The catch-up

If a fund has a hurdle, it usually also has a catch-up. Once LPs have received their preferred return, the GP receives a large share (sometimes 100%) of the next distributions until the GP has "caught up" to its full 20% of total profits. After that, profits are split 80/20.

The effect: if the fund does well, the GP ends up with 20% of all profits, just as if there had been no hurdle. The hurdle only protects LPs when returns are modest.

European vs American waterfalls

The order in which carry is paid makes a big difference to when the GP gets paid.

European (whole-of-fund) waterfall

The GP receives carry only after LPs have received back all their contributed capital across the whole fund, plus any hurdle. It's more LP-friendly because the GP waits until the fund as a whole is in profit.

American (deal-by-deal) waterfall

The GP can receive carry on each successful investment as it's sold, provided certain conditions are met, even if other investments later lose money. It's more GP-friendly because carry arrives earlier.

Because deal-by-deal carry can result in the GP being overpaid if later deals do badly, American waterfalls usually come with stronger clawback provisions.

Clawback

A clawback requires the GP to return carry it received if, at the end of the fund, it turns out to have been paid more than its agreed share of total profits. Clawbacks are common in both structures but matter most in deal-by-deal waterfalls.

Clawbacks are only as good as the GP's ability to pay. LPs often ask for escrow of a portion of carry, or personal guarantees from individual partners, to make clawbacks effective. Clawback amounts are often calculated net of taxes the GP already paid on the carry.

How carry is split within a firm

The carry belongs to the GP entity, which then allocates it among partners and staff. Allocation is usually set at the start of each fund in "carry points". Senior partners typically hold most of it. Junior staff may receive smaller allocations that vest over time.

Common features:

• Vesting: carry allocations often vest over several years, with forfeiture if someone leaves early.
• Good leaver / bad leaver: how much carry a departing person keeps depends on the circumstances of their departure.
• Fund-by-fund allocation: each fund has its own carry pool, so people hired later may have no carry in earlier funds.

Tax treatment

The tax treatment of carried interest has been politically controversial for many years. In some countries, carry may be taxed as a capital gain rather than ordinary income, subject to holding period requirements and other conditions. In the US, for example, there's a three-year holding period requirement for long-term capital gains treatment on carry. Rules differ significantly by country and change with legislation, so fund managers need specialist tax advice.

What LPs negotiate

• carry percentage, especially for first-time or larger funds,
• hurdle rate and catch-up terms,
• European vs American waterfall,
• clawback strength, escrow and guarantees,
• management fee offsets (sharing of transaction and monitoring fees),
• GP commitment level.

Our guide on raising a first-time fund covers how emerging managers typically approach these terms.

Management fee vs carry: why both exist

The management fee keeps the lights on regardless of performance. Carry rewards success. A common LP concern is that in very large funds, the management fee alone can make managers wealthy, weakening the incentive provided by carry. That's one reason LPs pay close attention to fee levels as funds grow and why smaller funds sometimes have higher fee percentages.

How fees affect carry: a fuller example

The earlier examples ignored management fees to keep things simple. In practice, fees are part of the capital LPs contribute, and in most funds LPs must get back all contributed capital, including what went to fees, before carry is paid.

This gross-to-net gap is why LPs focus closely on fee levels and why they ask managers to report both gross and net performance.

Carry and GP alignment over time

Carry only works as an incentive if the GP believes it will be paid. If a fund is performing poorly and carry looks out of reach, the GP's incentive weakens, which can affect how actively they manage the remaining portfolio. LPs watch for this, especially in older funds. Conversely, if a GP is about to raise a new fund, they may be tempted to sell assets early to show realised returns. Good governance, including an active LP advisory committee and clear valuation policies, helps manage these tensions.

Measuring fund performance

When evaluating carry, LPs and managers use several metrics side by side:

• TVPI (total value to paid-in): distributions plus remaining value, divided by contributed capital.
• DPI (distributions to paid-in): actual cash returned, divided by contributed capital. Carry is usually paid from DPI, not paper value.
• IRR: the annualised return, which is sensitive to timing.

A fund can show a strong TVPI on paper while its DPI is still low, which is why carry often isn't paid until late in a fund's life.