Carried Interest

How carried interest works

Carried interest is the manager's share of a fund's profits. Cambridge Associates defines it as the performance-based compensation for the general partner, also called the carry, profit share or override, and states that in general it is a fixed percentage, 20 percent, of cumulative net gains of the partnership. The Institutional Limited Partners Association describes it as an entitlement accruing to the fund's management company that becomes payable once investors have recovered their initial investment plus any hurdle rate.

The arithmetic at the fund level is simple; the sequencing is where the money actually moves.

Carry = carry rate x (cumulative distributions - capital contributed - preferred return, where applicable)

Nothing is paid by that formula directly. Proceeds run through the distribution waterfall in the limited partnership agreement, and carry is whatever falls out of the general partner tier. A conventional whole-of-fund waterfall has four steps: return of all contributed capital, then the preferred return, then a general partner catch-up, then a residual split at the carry rate.

The catch-up is the step people misread. Where a fund has a soft hurdle, the general partner receives all or most of the next distributions after the preferred return until it holds its full carry percentage of total profits. The catch-up amount solves an equation rather than being a fixed number:

Catch-up = carry rate x preferred return paid / (1 - carry rate)

With a hard hurdle, there is no catch-up. The general partner takes its percentage only of profits above the hurdle, and the preferred return stays permanently with the limited partners. ILPA's Principles recommend that structure, stating that to mitigate investor risk the carry calculation should ideally use a hard hurdle whereby the general partner's carried interest is based only on the portion of profits that exceed the preferred return.

Two waterfall shapes then determine when carry is paid rather than how much is ultimately owed. Under a whole-of-fund waterfall, which ILPA calls best practice, all contributions plus the preferred return come back before any carry is paid. Under a deal-by-deal waterfall, carry is paid as individual investments are realized, which pays the manager sooner and creates the risk of overpayment if later investments lose money. For models other than whole of fund, ILPA recommends that accrued carried interest be held in escrow with significant reserves, giving 30 percent of carry distributions or more as an example.

ILPA's Principles add several calculation rules worth knowing: carry should be computed on net profits rather than gross, factoring in fund-level expenses; it should be computed on an after-tax basis; and no carry should be taken on current income distributions.

Tax treatment is separate from the economics. Under section 1061 of the Internal Revenue Code, effective for tax years beginning after 31 December 2017, gain allocated through an applicable partnership interest, which is an interest received in connection with performing services in an investment business, needs a holding period of more than three years to qualify for long-term capital gain treatment. Shorter holds are recharacterized as short-term.

Worked example

Suppose a 40 million dollar venture fund with a 20 percent carry, a whole-of-fund waterfall and no preferred return, which is the common venture arrangement. All figures are hypothetical.

Over the fund's life, limited partners contribute the full 40 million dollars, and the fund distributes 120 million dollars in total.

Step one: return of capital. The first 40 million dollars of distributions go entirely to limited partners. No carry is payable yet.

Step two: profit. Distributions above contributed capital are 120 minus 40, equals 80 million dollars.

Step three: the split. The general partner takes 20 percent of 80 million, or 16 million dollars. Limited partners receive the other 64 million, plus the 40 million returned in step one, for 104 million dollars total.

Step four: gross versus net. The fund's gross multiple is 120 / 40 = 3.0x. The multiple limited partners actually receive is 104 / 40 = 2.6x, and it would be lower still after management fees, which this example ignores. The 0.4x gap is the carry.

Now change only the waterfall shape. Suppose the same fund used a deal-by-deal structure and its first exit, in year four, returned 30 million dollars on a 4 million dollar investment. On a deal-by-deal basis the manager would be entitled to carry on that single realization immediately, roughly 20 percent of the 26 million dollar gain, or 5.2 million dollars, years before anyone knows what the rest of the portfolio does. If the remaining 36 million dollars of cost ultimately returns only 20 million, the fund's lifetime profit is far smaller than that early payment implied, and the manager owes money back.

That repayment is the clawback. ILPA recommends that clawback amounts be gross of taxes paid and repaid no later than two years following recognition of the liability, that actual and potential clawback liabilities be disclosed as of the end of every reporting period, and that the clawback period extend beyond the fund's term. It also strongly encourages joint and several liability among individual general partner members, or a creditworthy guarantee where that is not provided.

Where it shows up

In the limited partnership agreement, carried interest lives in the distributions article. The clause reads as an ordered list of tiers: first to the partners until each has received an amount equal to its capital contributions, then until each has received the preferred return, then to the general partner until it has received a stated percentage of amounts distributed above return of capital, then the balance a fixed percentage to the partners and a fixed percentage to the general partner. ILPA asks that these provisions be drafted so a non-legal professional can follow them, and that investors be given a model of how fees, expenses and carried interest will be calculated over the life of the fund.

In the private placement memorandum's summary of terms, carry appears as a single line next to the management fee, the preferred return and the waterfall type. That line is the first thing an experienced limited partner reads, and the waterfall type matters as much as the percentage.

In the general partner entity's own operating agreement, carry is divided among individuals as points, with a vesting schedule and treatment on departure. This is a separate negotiation from the fund's terms and is invisible to limited partners.

In the quarterly report, accrued carried interest appears as a liability of the fund or a reduction in limited partner capital accounts, reflecting what the general partner would receive if the portfolio were liquidated at current marks. ILPA's reporting standards and diligence questionnaires ask for carry and clawback obligations to be disclosed explicitly.

For tax, carry flows through to the recipient on a Schedule K-1, with the character of the underlying gain, subject to the section 1061 three-year holding period test for applicable partnership interests.

Common mistakes

• Treating 20 percent as a rule. Cambridge Associates describes it as the general case, not a requirement. Rates and structures vary, and the waterfall shape often matters more than the rate.
• Confusing carry with the management fee. The fee pays for operations and is charged whether or not the fund makes money. Carry is a share of profits.
• Reading accrued carry as earned carry. Accruals move with marks and reverse when marks fall.
• Missing the difference between a hard and a soft hurdle. With a catch-up, the general partner ends up with its full percentage of all profits. Without one, it gets its percentage only of the excess.
• Assuming a deal-by-deal fund pays more in the end. It pays earlier. The lifetime total is governed by the clawback, if the clawback is actually collectible.
• Ignoring who guarantees the clawback. A promise from an entity with no assets is not the same as joint and several liability or a parent guarantee.
• Forgetting the three-year holding period. Under section 1061, gains allocated on an applicable partnership interest held three years or less are recharacterized as short-term.

Related terms

Carried interest is the output of the distribution waterfall and is gated by the hurdle rate, protected for limited partners by the clawback, and paired with the management fee as the two halves of manager compensation. It is earned by the general partner and paid out of proceeds otherwise going to limited partners, and it sits alongside the GP commitment as the manager's stake in outcomes.

Frequently asked questions

What is carried interest in simple terms?

It is the fund manager's cut of the profits. Investors get their money back first, and usually a minimum return on top of it, and then the manager keeps a share of what is left over, most commonly around 20 percent. It is the part of a manager's pay that only exists if the fund actually makes money.

Why is carry usually 20 percent?

Convention, reinforced by benchmark providers describing it that way. Cambridge Associates defines carried interest as generally a fixed 20 percent of cumulative net gains of the partnership. There is nothing legally fixed about the number; established managers sometimes charge more, and first-time managers sometimes accept less or accept a structure less favorable to themselves in order to close a fund.

What is the difference between carried interest and a management fee?

The management fee is compensation for running the fund, charged annually against committed or invested capital and payable regardless of performance. Carried interest is a profit share, payable only after capital and any preferred return have been distributed to investors. Fees are certain; carry is not.

When is carried interest actually paid?

It depends on the waterfall. Under a whole-of-fund structure, not until all contributed capital and the preferred return have been distributed, which in venture often means year seven or later. Under a deal-by-deal structure, carry can be paid on each realization, subject to escrow arrangements and a clawback. ILPA calls the whole-of-fund model best practice and recommends substantial escrow where it is not used.

How is carried interest taxed?

It flows through as the character of the fund's underlying gains, which for a holder of an applicable partnership interest means section 1061 applies: the gain must be from assets held more than three years to qualify as long-term capital gain, otherwise it is recharacterized as short-term. The rule has applied to tax years beginning after 31 December 2017. Individual circumstances vary and this is not tax advice.

What is a carry clawback?

It is the manager's obligation to give back carry it was paid earlier if, measured across the whole fund at the end, it received more than the agreed share of profits. It matters most in deal-by-deal structures where early winners can trigger payments that later losses invalidate. ILPA recommends disclosure of actual and potential clawback liabilities every reporting period and repayment within two years of the liability being recognized.

Related tools and reading

• Carry Calculator
• Waterfall Calculator
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• Venture Capital Salary Guide