Carried interest is the share of investment profits that a general partner receives as compensation for managing a fund, payable after limited partners have received their committed capital back and, in most structures, a preferred return above a specified hurdle rate. It is the primary performance-based component of GP compensation and is typically set at 20% of profits, though rates vary by fund type and manager.
How it works
Carried interest is not a fee charged to LPs; it is a profit allocation specified in the LPA that redirects a portion of distributable proceeds from LPs to the GP. The distinction matters because carried interest is generally taxed as capital gain in the hands of the GP (subject to jurisdiction-specific rules and periodic legislative attention) whereas a management fee is taxed as ordinary income. The tax treatment of carried interest has been a recurring policy debate in multiple jurisdictions.
The mechanics of when and how carried interest is paid depend on the waterfall structure. In a European (whole-fund) waterfall, carry is payable only after the fund has returned all LP contributed capital and paid the preferred return across all investments. This means the GP receives no carry until late in the fund's life, even if early investments perform well. In an American (deal-by-deal) waterfall, carry can flow after each investment realisation that clears the hurdle, making the GP's carry receipts earlier and more predictable but requiring clawback provisions to correct overpayments if later investments underperform.
The 20% carry rate is the institutional standard for PE and VC funds. Private credit funds often use lower carry rates (10-15%) or no carry at all, particularly for senior secured strategies where the return profile is income-driven and the GP's alpha contribution is structured as credit selection rather than value creation. Some high-performing PE managers command carry rates of 25-30% for top-quartile performance, with performance-conditioned step-ups specified in the LPA.
From a fund administration perspective, carried interest creates ongoing calculation complexity. The administrator must track the GP's cumulative carry entitlement across multiple distribution events, maintain the GP catch-up deficit position, and compute the clawback exposure (the amount the GP would need to return if the fund ultimately fails to deliver the hurdle return). These calculations are inputs to LP reporting and, increasingly, to fund audit processes.
Worked example
Bridgemont Capital Fund V has 20% carried interest, an 8% preferred return, and a European waterfall. The fund has GBP 500M in committed capital, all of which is contributed. At final distribution, proceeds total GBP 850M.
Tier 1 (return of capital): GBP 500M to LPs. Remaining: GBP 350M.
Tier 2 (preferred return, 8% compounded, average holding 6 years): approximate preferred return on GBP 500M over 6 years = GBP 500M x [(1.08)^6 - 1] = GBP 264M. This exceeds remaining GBP 350M after Tier 1? No: GBP 350M exceeds GBP 264M (the preferred return). Preferred return paid: GBP 264M. Remaining: GBP 86M.
Tier 3 (GP catch-up): GP target = 20% of total profits (GBP 350M) = GBP 70M. GP receives GBP 70M. Remaining: GBP 16M.
Tier 4 (80:20 split): LPs GBP 12.8M, GP GBP 3.2M.
Total LP distributions: GBP 776.8M. Total GP carry: GBP 73.2M (approximately 20.9% of GBP 350M total profit, the small excess reflecting the compounding and catch-up mechanics). The administrator documents each tier calculation in the distribution notice supporting schedule provided to LPs.
Frequently asked questions
Why is carried interest taxed as capital gains rather than income? In most PE jurisdictions, carried interest is structured as a profits interest in the partnership rather than a fee, which characterises it as capital gain (taxed at preferential rates) rather than ordinary income. This characterisation is disputed by tax authorities in some jurisdictions and has been partially limited by legislation in the UK (two-year holding period requirement) and debated in the US. Tax treatment of carried interest is jurisdiction-specific and subject to change; investors and GPs should take specific advice.
What is a clawback and how does it relate to carried interest? A clawback is the GP's obligation to return previously received carried interest if, at the end of the fund's life, the GP has been paid more carry than its correct entitlement calculated on a whole-fund basis. Clawbacks are most relevant in deal-by-deal waterfall funds where carry is paid early. In a European waterfall, clawback risk is lower because carry is only paid once all LP capital has been returned, but it still arises in theory if distributions reduce and capital is recalled or losses are recognised after carry distributions have been made.
Is 20% carry always appropriate for private credit funds? No. Private credit funds, particularly senior secured strategies, often use lower carry rates (10-15%) because their expected returns are lower and more predictable than PE equity returns. Some credit funds use no carry at all, monetising through management fees and origination fees. The appropriate carry rate reflects the risk-return profile of the strategy and the competitive dynamics of the manager's fundraising market.
How does carried interest affect LP net returns? Carry is one of the two main cost components of private fund investing, alongside the management fee. A 20% carry on a fund that generates 3x gross returns reduces LP net returns by approximately 7-9 percentage points, depending on the waterfall structure and preferred return mechanics. LPs model carry costs as part of their net return expectations at commitment, using J-curve projections and scenario analysis.
Related terms
Distribution waterfall, Preferred return, Hurdle rate, GP catch-up, Clawback, Management fee, Capital account
Related pages
Waterfall mechanics in private fund administration, Swelv for fund administrators