What Is Carried Interest in a Fund and How Does It Work?

Carried interest is a compensation structure within certain investment funds, representing a share of the profits earned by the fund’s managers from successful investments. It is a common practice in the private equity, venture capital, and some hedge fund industries, serving as a significant incentive for fund managers to maximize returns. This profit-sharing mechanism aligns the interests of those managing the capital with those who provide it.

Defining Carried Interest

Carried interest, often referred to as “carry,” is a performance-based fee paid to investment fund managers, specifically General Partners (GPs), for their role in generating profits from the fund’s investments. This compensation differs from management fees, which are a fixed percentage of the assets under management and are paid regardless of performance. The primary purpose of carried interest is to incentivize fund managers to achieve high returns for their investors, known as Limited Partners (LPs).

This structure directly links manager compensation to the fund’s investment success, aligning the interests of GPs and LPs. Managers receive a portion of the profits only if the fund performs well and surpasses certain agreed-upon thresholds. This model encourages managers to make investment decisions that aim for substantial gains, as their own financial rewards are directly tied to the investors’ returns. Carried interest is a standard practice in private equity funds, venture capital funds, and some hedge funds, where managers actively seek to grow the value of their portfolio companies.

Calculating Carried Interest

Carried interest calculation involves several specific components that ensure investors receive their expected returns before managers participate in the profits. A primary element is the “hurdle rate,” also known as the “preferred return.” This is the minimum rate of return that investors must achieve on their capital before the fund managers are eligible to receive any carried interest. For example, if a fund has an 8% hurdle rate, investors must first earn an 8% annual return on their investment. Hurdle rates commonly range from 7% to 9% per annum and are cumulative and compounded annually.

Following the hurdle rate, a “catch-up” clause often comes into play. Once the preferred return is met, this provision allows the fund managers to “catch up” to their full percentage of the profits. For instance, if the carried interest percentage is 20%, the catch-up mechanism ensures that managers receive a larger share of subsequent distributions until their total profit share reaches the agreed-upon 20% of all profits, including those initially used to satisfy the hurdle rate for investors.

The carried interest percentage is typically 20% of the fund’s profits, though this can vary depending on the fund’s terms and investment strategy. This percentage is applied to profits that exceed the hurdle rate and any catch-up provisions. The exact details of how carried interest is calculated and distributed are outlined in the fund’s offering documents, specifically in the Limited Partnership Agreement (LPA).

Clawback provisions are another important mechanism within carried interest agreements. These contractual clauses allow investors to reclaim carried interest previously paid to managers if the fund’s overall performance later falls below the agreed-upon hurdle rate or if managers received an excessive share of profits. Clawbacks are calculated when a fund is liquidated, ensuring that managers only retain carried interest if the fund’s cumulative performance ultimately justifies it. This protects investors from situations where early successful deals might lead to premature payouts to managers, only for later investments to underperform.

Carried interest is calculated on a “fund-as-a-whole” basis, also known as a European-style waterfall, rather than a “deal-by-deal” basis. Under the fund-as-a-whole approach, managers do not receive carried interest distributions until investors have recovered all their capital contributions to the entire fund and achieved their preferred return. This method accounts for all gains and losses across the fund’s entire portfolio. In contrast, a deal-by-deal (American-style) waterfall allows managers to receive carry on individual successful investments, potentially before the overall fund has returned capital to investors.

For federal tax purposes, carried interest is treated as a return on investment rather than ordinary income, qualifying for preferential capital gains tax treatment. The top federal tax rate for long-term capital gains is 20%, plus a 3.8% net investment income tax, totaling 23.8%, which is lower than the top ordinary income tax rate of 37%. To qualify for long-term capital gains treatment, assets underlying the carried interest must be held for more than three years. Additionally, carried interest is not subject to self-employment taxes, such as Medicare and Social Security, which further distinguishes its tax treatment from salary or wage income.

Distribution and Investor Considerations

The distribution of profits from a fund’s investments, including carried interest, follows a structured process known as a “distribution waterfall.” This waterfall outlines the specific order in which cash distributions are allocated among investors and fund managers. The design of the distribution waterfall is a key aspect of the fund’s operating agreement, ensuring transparency and adherence to agreed-upon terms.

A distribution waterfall comprises distinct tiers, each representing a stage of profit allocation. The initial tier is the “Return of Capital,” where investors first receive back their entire initial invested capital. Until investors have recouped their principal contributions, no profits are distributed to managers.

Following the return of capital, the next tier addresses the “Preferred Return.” In this stage, investors receive distributions until they have achieved their agreed-upon minimum rate of return on their invested capital, as defined by the hurdle rate. Only after both the initial capital and the preferred return have been distributed to investors does the fund move to the subsequent tiers involving manager compensation.

The “Catch-up” tier is next, allowing the fund managers to receive a significant portion of the distributions until their share of the total profits reaches the predetermined carried interest percentage. This mechanism ensures that managers receive their full proportionate share of profits. Finally, once the previous tiers are satisfied, the remaining profits are split according to the agreed-upon carried interest percentage, typically with 80% going to investors and 20% to managers.

This tiered structure of carried interest, integrated within the distribution waterfall, aligns the financial interests of fund managers with those of their investors. Managers are directly incentivized to maximize the fund’s overall performance because their compensation, the carried interest, is contingent upon the fund exceeding specific return thresholds for investors. This alignment fosters investor confidence, as managers’ financial success is directly linked to the investors achieving their target returns.