Carried Interest

Carried interest, often shortened to carry, is the portion of the profits of a private investment fund that is allocated to the fund's manager as a reward for performance. It is paid only if the fund makes money for its investors, and usually only after they have received back their contributions plus a minimum return. The customary share is 20% of profits, though the figure is negotiated fund by fund.

Carry is the main incentive in private equity, the venture capital fund, private credit and real estate funds. It sits alongside the management fee, an annual charge based on commitments or invested capital that covers the manager's running costs. The two together are sometimes described as "two and twenty". Carry goes to the general partner and, through it, to the individual investment professionals, who typically also invest their own money through a general partner commitment.

The order in which a fund's proceeds are shared between investors and manager is set out in the distribution waterfall. A common structure has four steps. First, investors receive back the capital they contributed. Second, they receive a preferred return, often 8% a year, on that capital; this threshold is also called the hurdle rate. Third, the manager receives all or most of the next profits until it has caught up to its agreed share of total profit. Fourth, remaining profits are split, typically 80% to investors and 20% to the manager.

A simplified example: a fund draws 100 million from investors and, some years later, returns 200 million. Profit is 100 million. Provided the preferred return has been met and the catch-up is complete, the manager's carry is 20 million and investors receive 180 million in total.

Two models govern when carry is paid:

• Whole-fund, or European, waterfall. The manager receives no carry until investors have received back all contributed capital across the whole fund, plus the preferred return. Carry arrives late in the fund's life, and overpayment is unlikely.
• Deal-by-deal, or American, waterfall. Carry is calculated on each investment as it is sold, usually after returning the capital for that deal and any realised losses to date. The manager is paid sooner, but early successes followed by later losses can leave it with more than its share.

The second model therefore depends on a clawback provision, which obliges the manager to return excess carry at the end of the fund. To back that promise, part of each carry payment may be held in an escrow holdback, and individual recipients may give personal guarantees.

Hedge funds charge a performance fee that serves the same purpose but works differently. It is calculated each year on gains in net asset value, including unrealised gains, and is protected by a high-water mark so that the manager is not paid twice for recovering earlier losses. Carried interest in closed-ended funds is based on realised cash proceeds over the entire life of the fund, which may be ten years or more, and is measured against money actually contributed by each investor under its limited partner commitment. A hedge fund manager is thus paid on valuations, while a private equity manager is paid on exits.

Within a management firm, carry is divided among partners and staff by an allocation set for each fund. Shares usually vest over several years, and a person who leaves early may forfeit unvested points.

The taxation of carry has been debated for decades. Because it is structured as a share of partnership profits and not as a fee, in many countries it takes on the character of the underlying profit, which is mostly capital gain, and is taxed at the capital gains tax rate. Critics argue that carry is in substance pay for services and should be taxed as income at higher rates. Defenders respond that it is a return on an entrepreneurial, at-risk interest and that favourable treatment encourages long-term investment.

Rules have tightened without settling the argument. In the United States, legislation in 2017 extended the holding period required for long-term capital gains treatment of carried interest to more than three years. The United Kingdom raised the rate applied to carry in 2025 and legislated to bring it within the income tax system from April 2026, with a discount for carry that meets qualifying conditions.

Investors accept carry because it aligns the manager's reward with their own outcome, but the details are contested. A fund without a hurdle pays carry on any profit, however small. A full catch-up means that, once the hurdle is cleared, the manager ends up with 20% of all profit and not just the profit above the hurdle. Deal-by-deal structures and the use of subscription credit lines, which can lift the measured internal rate of return (IRR) and help clear the hurdle earlier, favour the manager.

There is also a concern about risk taking. Carry gives the manager a share in gains without a matching share in losses beyond its own investment, which may encourage higher leverage or riskier deals when a fund is below its hurdle. Industry bodies representing investors publish principles recommending whole-fund waterfalls, meaningful hurdles, strong clawbacks and clear disclosure of carry calculations.