Carried Interest
Definition
Carried interest (or “carry”) is the share of a fund’s profits allocated to the General Partner (GP) as a performance incentive. It is earned only after investors (LPs) have received their capital back plus a minimum return (the preferred return or hurdle rate). It is the primary way GPs are compensated for investment outperformance, and its structure directly affects LP net returns.
Caveat on conventions: The figures quoted here (20% carry, 8% hurdle) reflect common market conventions in PE. These terms vary significantly by manager, fund type, strategy, fund size, vintage, and LP negotiating leverage. Some funds have no hurdle rate; some charge carry above 20%; others less. Always read the LPA.
Why It Matters
Carried interest is the mechanism by which GPs share in fund upside. Understanding it is essential for:
- LPs – assessing the total cost of investing in a fund and the degree of GP alignment
- Operations teams – calculating distributions and implementing waterfall mechanics correctly
- Finance professionals – modelling fund economics and net LP returns
Carry creates alignment: GPs only receive it if LPs do well first. But it is also a cost that reduces LP net returns.
The Carry Structure
Carry is calculated within the fund’s distribution waterfall. The key components are:
1. Preferred Return (Hurdle Rate) The minimum rate of return LPs must receive before any carry is paid. In PE, a rate in the range of 6–9% per annum (compounded) is common, though it varies. Some funds – particularly in venture capital and certain hedge funds – operate with no hurdle.
2. GP Catch-Up Once the hurdle is met, the GP receives distributions in the catch-up tier until they have received a specified percentage of total profits above return of capital (the “catch-up to carry” level). The catch-up rate (how fast this happens) is specified in the LPA. A 100% catch-up means the GP receives all distributions in this tier; a 50% catch-up means GP and LP share equally until the carry percentage is reached.
3. Carried Interest Split After the catch-up, remaining profits are split between LPs and the GP per the carry percentage. A common split is 80% to LPs and 20% to the GP, though this varies.
Worked Example: European Waterfall Carry
Assumptions (illustrative only):
- LP capital invested: £100m (total paid-in)
- Total exit proceeds: £165m
- Hurdle rate: 8% per annum, compounded, over 5 years
- Carry: 20%
- Catch-up: 100%
Step 1: LPs receive return of capital: £100m. Remaining: £65m.
Step 2: LPs receive preferred return (compound): £100m × (1.08⁵ – 1) ≈ £47m. Remaining: £65m – £47m = £18m.
Step 3: GP catch-up. Total profit above return of capital = £65m. 20% of £65m = £13m. GP receives £13m (100% catch-up). Remaining: £18m – £13m = £5m.
Step 4: Remaining £5m split 80/20: LP receives £4m. GP receives £1m.
Total carry to GP: £13m + £1m = £14m Total to LP: £100m + £47m + £4m = £151m Verification: £151m + £14m = £165m ✓
Note: This example uses compounded preferred return, which is correct for most LPAs. Simple interest approximations (e.g., 8% × 5 = 40%) are sometimes used in informal explanations but understate the true hurdle by several million pounds over a typical fund life.
What Happens If the Fund Underperforms
If the fund does not clear the hurdle rate across its life, the GP earns no carry. In a European waterfall, the GP earns management fees but zero carry if total distributions to LPs do not exceed capital returned plus the preferred return.
In an American (deal-by-deal) waterfall, carry may have been paid on early exits; if later exits underperform, a clawback provision requires the GP to return the excess. In practice, clawback recovery is often incomplete. See Clawback and Waterfalls.
Gross vs Net: The LP Impact
For LPs, carry is a real cost. A gross IRR of 20% may become a net IRR of 14–16% after management fees and carry. The precise impact depends on timing (when carry is earned), the hurdle mechanics, and the fee basis. See fee calculations for the interaction between management fees, carry, and LP net returns.
Tax Treatment
In the UK and US, carried interest received by GP partners has historically been taxed at capital gains rates rather than income tax rates, because it is structured as a share of investment profits rather than salary. This treatment has been a subject of policy debate and is subject to legislative change. It is jurisdiction-specific; do not generalise across countries.
Related Files
Manual Review Notes
- The worked example uses a 5-year fund life with all capital invested on day one for simplicity. In practice, capital is called over 3–5 years, making the carry calculation significantly more complex (each tranche of capital has a different preferred return start date). A more realistic multi-tranche example would be a useful future addition.
- UK and US tax treatment of carry is subject to active legislative development. This section should be reviewed whenever major tax legislation is enacted. Do not cite specific tax rates.
- “Carry percentage” conventions differ by fund type. VC funds, infrastructure funds, and hedge funds may use very different carry structures. This file focuses on PE conventions.