What Is Carried Interest?
Carried interest, commonly called “carry”, is the share of profits that private equity, venture capital, real estate, and other alternative investment fund managers earn as a performance incentive. Unlike a management fee (typically 1.5–2% of committed capital), which is fixed and paid annually, carried interest is contingent on fund performance. If the fund does well, managers share in the upside.
The industry standard is 20% of profits, though it can range from 10% to 30% depending on fund strategy, size, and investor negotiations. This structure is designed to align the interests of general partners (GPs) with those of limited partners (LPs).
How Does It Work?
A simplified example:
A private equity fund raises $500 million.
After several years, the fund exits its investments and returns $800 million to investors.
The profit is $300 million.
If the carry is 20%, the GP earns $60 million in carried interest.
However, this payout only occurs after LPs receive their contributed capital and a preferred return if there is one (often 8%). This ensures that GPs only earn carry when investors achieve a minimum return.
The Waterfall Structure
Carried interest is distributed through a waterfall, a tiered framework that dictates the order of payments:
Return of Capital: 100% of distributions go to LPs until they recover their initial investment.
Preferred Return (Hurdle Rate): LPs receive a minimum return, typically 6–8% annually.
Catch-Up: After the hurdle is met, 100% of distributions may go to the GP until they “catch up” to their agreed share (usually 20% of total profits).
Carried Interest Split: Remaining profits are split, commonly 80% to LPs and 20% to the GP.
American vs. European Waterfalls:
American (Deal-by-Deal): GPs can receive carry after each successful deal, subject to clawback provisions.
European (Whole-of-Fund): GPs only receive carry after the entire fund returns all capital and preferred return to LPs. This is more investor-friendly and common with institutional LPs.
Key Terms
Hurdle Rate: The minimum return LPs must receive before GPs earn carry (often 6-8%).
Catch-Up: A phase where GPs receive 100% of profits until they reach their agreed share.
Clawback: A provision requiring GPs to return excess carry if later investments underperform, ensuring LPs receive their agreed share overall.
Why Is It Taxed as Capital Gains?
Under U.S. tax law, carried interest is generally treated as a profits interest in a partnership. If the underlying assets are held for more than three years, the GP’s share qualifies for long-term capital gains rates (20% plus 3.8% NIIT) instead of ordinary income rates (up to 37%).
This preferential treatment, often called the “carried interest loophole”, is controversial. Critics argue it’s compensation for services and should be taxed like wages. Supporters claim it reflects entrepreneurial risk and aligns incentives.
Current Tax Reform Proposals
The debate is active in 2025. Recent developments include:
Bipartisan proposals to eliminate favorable tax treatment for carried interest, taxing it as ordinary income.
President Trump and congressional leaders have discussed ending the preference entirely.
Democrats introduced the Carried Interest Fairness Act of 2025, which would recharacterize carried interest as ordinary income and apply self-employment taxes.
If enacted, these changes would significantly increase the tax burden on fund managers and alter fund economics.
Why It Matters
For GPs, carried interest is the primary wealth driver. For LPs, understanding carry is essential to evaluating net returns and alignment. For policymakers, it remains a focal point in tax fairness debates.