Definition
– Carried interest (often called “carry”) is the share of a fund’s profits that the general partners (GPs) receive as performance compensation. Limited partners (LPs) supply most of the capital; GPs manage the fund and earn carry only if the fund’s returns exceed any agreed thresholds.
How carried interest works — step by step
1. Capital is raised: LPs commit capital; GPs typically take a small ownership stake and manage investments.
2. Management fees: GPs usually charge an annual management fee (commonly ~2%) to cover operating costs. This is paid regardless of performance.
3. Return of capital: When assets are sold, invested capital is returned to LPs first.
4. Hurdles / preferred return: Many funds require a minimum return (a “hurdle”) to LPs before carry is paid. If that threshold exists, LPs receive preferred returns before the GP gets carried interest.
5. Carried interest allocation: After return of capital and satisfying any hurdles, the remaining profit is split according to the waterfall. A typical split is 80% to LPs and 20% to GPs — hence the common “20% carry.”
6. Clawback and final accounting: If interim distributions caused the GP to receive more than it should under the final accounting, a clawback clause can require the GP to return the excess to LPs.
7. Vesting: Carry often accrues gradually (vests) over the life of the fund, tying GP pay to long-term results.
Key terms (brief)
– General partner (GP): the manager running the fund.
– Limited partner (LP): outside investors providing capital.
– Hurdle / preferred return: minimum return LPs receive before carry is paid.
– Waterfall: the sequence and percentages used to distribute proceeds.
– Clawback: contractual right of LPs to reclaim excess carry paid earlier.
– Vesting: schedule over which a GP’s entitlement to carry becomes fixed.
Tax treatment (concise)
– Carried interest has historically been taxed at capital gains rates if the underlying investments meet the long-term holding requirement. After the U.S. Tax Cuts and Jobs Act (TCJA) changes, the applicable holding period for carry to qualify for long-term capital gains is generally three years. Long-term capital gains have a top federal rate of 20% (plus any applicable net investment income tax), compared with a top ordinary-income rate of 37%. These differences are central to ongoing political debate about tax fairness.
Worked numeric example
Assumptions:
– Fund committed capital: $100 million (LPs).
– Management fee: 2% per year (for illustration only; not used in carry calc below).
– Total cash proceeds at liquidation: $150 million.
– No hurdle preferred return in this example.
– Carry rate: 20% to GPs.
Step 1 — calculate profit:
– Profit = proceeds − returned capital = $150m − $100m = $50m.
Step 2 — allocate carry:
– GP carry = 20% × $50m = $10m.
– Remaining profit to LPs = 80% × $50m = $40m.
If a clawback is triggered
– Suppose interim distributions paid the GP $12m earlier. Final accounting shows GP’s rightful carry is $10m. The clawback provision would let LPs reclaim $2m from the GP.
Simple formula (for the common straight split case)
– GP carry = carry_rate × max(0, total_proceeds − capital_returned − any_preferred_return_amount)
Note: Actual waterfalls can include catch-up tiers and varying rates; read fund documents.
Why carry is controversial
– Critics: argue that taxing carry at capital gains rates gives fund managers lower tax bills than ordinary wages, creating perceived unfairness.
– Supporters
Supporters
– Argue carry aligns incentives: profit sharing links managers’ pay to fund performance, encouraging value creation and long-term thinking.
– Say carry compensates for risk and illiquidity: managers typically forgo current pay and tie compensation to future exits, bearing idiosyncratic, long-duration risk.
– Point to market pricing: carried interest is negotiated between sophisticated investors and managers; high carry reflects scarcity of top-performing managers and competition for talent.
– Note economic contribution: supporters contend private-capital activity (buyouts, venture investment) funds growth, restructuring, and job creation; carry is presented as payment for those services.
Policy debates and reform options
– Tax-rate change: subject carry to ordinary income rates rather than capital gains rates.
– Holding-period rules: require longer minimum holding periods before carried gains qualify as capital gains.
– Recharacterization rules: treat carry as compensation (wages) for payroll-tax purposes.
– Partial reforms: carve-outs for certain fund types (e.g., venture capital) or scale tax treatment by fund lifespan or investor types.
– Administrative fixes: tighten accounting, improve transparency, and strengthen clawback/enforcement mechanisms.
Each proposal has trade-offs: simplicity vs complexity, administrative burden, potential behavioral responses (changes in fund structures, migration to jurisdictions with different tax regimes).
Worked example — tax-status impact (illustrative only)
Assumptions (U.S., federal tax only, no state tax, no Net Investment Income Tax (NIIT) unless stated):
– GP carry received: $10,000,000.
Scenario A — taxed as long-term capital gain at 23.8% (20% federal rate + 3.8% NIIT):
– Tax = 0.238 × $10,000,000 = $2,380,000.
– After-tax = $7,620,000.
Scenario B — taxed as ordinary income at 37%:
– Tax = 0.37 × $10,000,000 = $3,700,000.
– After-tax = $6,300,000.
Difference:
– Additional tax if taxed as ordinary income = $3,700,000 − $2,380,000 = $1,320,000.
Notes: This is a simplified illustration. Actual tax outcomes depend on state taxes, the taxpayer’s full income profile, NIIT applicability, timing, legal form of interest, and current law.
How carried interest is implemented (practical checklist for LPs or students)
When reviewing fund documents (private-placement memorandum, limited partnership agreement, subscription agreement), verify:
1. Carry rate: what percentage of profits the GP receives.
2. Hurdle (preferred return): minimum LP return before carry applies.
3. Catch-up provision: whether and how the GP “catches up” after hurdle is met.
4. Waterfall style: deal-by-deal vs whole-fund (American vs European waterfall).
5. Clawback mechanics: final true-up rules and timing for reimbursements.
6. GP commitment: how much GP capital is invested (skin in the game).
7. Distribution timing: how and when profits are distributed and carry crystallized.
8. Tax allocations: how partnership items are allocated and how tax liabilities flow to partners.
9. Transferability and liquidity of GP interest.
10. Side letters or exceptions that grant preferential economics to some LPs.
Common waterfall structures (brief)
– European waterfall (whole-fund): LPs must receive entire return of capital and any preferred return for the whole fund before GP
receives carried interest. After LPs have been fully repaid and any preferred return met for the whole fund, the GP typically receives a catch‑up portion so that the agreed split of profits (the carried interest) is achieved across the fund’s lifetime.
American waterfall (deal‑by‑deal): carried interest is calculated and paid as each investment is realized. The GP may receive carry on profitable deals before the entire fund returns capital to LPs. This structure is faster for the GP but often incorporates a clawback mechanism that forces a GP true‑up at fund close if early carry payments exceed the GP’s ultimate share once all results are aggregated.
Hybrid structures: combinations exist. For example, some funds pay deal‑by‑deal carry but retain a portion in escrow for later true‑up, or they apply a whole‑fund true‑up only if aggregate returns fall below a threshold. Variants are common and often tailored in side letters to specific LPs.
Worked numeric example — European (whole‑fund) waterfall
Assumptions:
– LP capital contributed: $100.0m
– Preferred return (hurdle): 8% per annum (assume for simplicity a single period = $8.0m)
– Total gross proceeds on liquidation: $150.0m
– GP carried interest: 20% on profits after hurdle
Step 1 — return capital + preferred to LPs:
– LP return of capital: $100.0m
– Preferred return: $8.0m
– Subtotal returned to LPs before carry: $108.0m
Step 2 — remaining proceeds to split:
– Remaining proceeds = $150.0m − $108.0m = $42.0m
– GP carry = 20% × $42.0m = $8.4m
– Remaining distributable to LPs = $42.0m − $8.4m = $33.6m
Net result:
– LPs total = $108.0m + $33.6m = $141.6m
– GP carry = $8.4m
(Management fees, taxes, and transaction expenses are excluded for clarity.)
Worked numeric example — American (deal‑by‑deal) with potential clawback
Assumptions:
– Same fund size and carry terms as above.
– First asset: cost $20m, sale proceeds $30m → profit $10m → GP paid 20% × $10m = $2.0m carry immediately.
– Later assets: combined outcome ephemeral; at final accounting total proceeds still
= $150.0m.
Continuing the deal‑by‑deal (American) example with a potential clawback
Worked numeric example — no clawback (recap)
– Fund size (LP capital): $100.0m. Preferred return (hurdle) to LPs: 8% on capital = $8.0m. So LPs must be returned $108.0m before carry.
– Total proceeds at final accounting: $150.0m.
– Remaining proceeds = $150.0m − $108.0m = $42.0m.
– GP carry = 20% × $42.0m = $8.4m. If the GP has already been paid $2.0m from the first deal, the GP is still entitled to an additional $6.4m at final settlement. No clawback is required.
Alternate outcome — clawback required
Assume the GP collected $2.0m carry on the first deal (20% × $10.0m profit). Later deals perform poorly so final total proceeds fall to $112.0m instead of $150.0m. Recalculate final entitlement:
Step 1 — amount due to LPs before carry
– LPs return of capital + preferred return = $108.0m (unchanged).
Step 2 — remaining proceeds to split
– Remaining proceeds = $112.0m − $108.0m = $4.0m.
– Final GP carry entitlement = 20% × $4.0m = $0.8m.
– But GP has already received $2.0m in interim carry.
Step 3 — clawback calculation
– Overpaid carry = interim carry paid − final carry entitlement = $2.0m − $0.8m = $1.2m.
– Clawback required: GP must return $1.2m to the fund (to be distributed to LPs) at final settlement, unless contractual mechanics (escrow, holdback, or offset with other compensation) already prevented the overpayment.
Notes and assumptions
– Assumes a simple carried interest waterfall with an 8% preferred return and 20% carry, and that management fees, taxes, and transaction costs are excluded from the numerical example.
– The clawback calculation is
The clawback calculation is performed at final fund settlement (liquidation or winding up) to compare the cumulative carried interest already paid to the GP against the GP’s ultimate entitlement based on total fund economics. If interim distributions resulted in the GP receiving more than its proportionate share of aggregate profits after accounting for the preferred return (the “hurdle”), the excess must be returned to the fund and reallocated to LPs.
How it’s computed (general formula)
– Total profits available to split = sum of all realized proceeds distributed to investors − total LP preferred return (if any) − any allowed deductions (fees, taxes, transaction costs), as defined in the limited partnership agreement (LPA).
– GP final carry entitlement = carry rate × max(0, Total profits available to split).
– Clawback required = max(0, Carry already paid to GP (interim total) − GP final carry entitlement).
Worked numeric recap (using earlier numbers)
– Carry already paid (interim): $2.0m.
– GP final entitlement (based on full fund): $0.8m.
– Clawback = $2.0m − $0.8m = $1.2m (GP must return $1.2m unless contractual mechanics prevented overpayment).
Common contractual mechanics that prevent or limit clawbacks
– Holdback/escrow: A portion of interim carried interest (often a percentage or fixed amount) is retained in escrow until final accounting. Example: if 60% of interim carry is escrowed, a $2.0m interim payment would leave $0.8m actually released and $1.2m held, covering the $1.2m clawback need on final settlement.
– GP capital commitment: GPs that invest meaningful own capital into the fund reduce mismatch risk; their remaining unfunded commitment or capital can be used to satisfy a clawback.
– Netting or offset rules: The LPA may permit offsetting overpaid carry against future carry that would otherwise be distributable to the GP from later profitable realizations.
– Deal-by-deal vs. whole-fund waterfalls: A deal-by-deal waterfall pays carry on each successful sale (risking overpayment later), while a whole-fund (or “European-style”) waterfall computes carry on aggregate fund profits (reducing clawback frequency).
Practical checklist for LPs and GPs when reviewing clawback language
– Trigger and timing: When will the final calculation be performed (e.g., final close, five years post-final distribution)?
– Calculation basis: Are realized values or mark-to-market valuations used? Are preferred returns compound or simple?
– Deductions and adjustments: Which fees, expenses, and taxes are deducted before calculating profits?
– Security for repayment: Is there an escrow, guaranty, or a GP capital commitment that secures potential clawbacks?
– Interest and tax treatment: Does the GP repay interest on clawed-back amounts? How are tax consequences allocated?
– Dispute resolution: Is there an independent auditor, an expert test, or arbitration clause for disagreements?
– Waterfall mechanics: Is carry calculated deal-by-deal, on a partially pooled basis, or on a whole-fund basis?
Example — escrow mechanics (numeric)
– Interim carry distributed (gross) = $2.0m.
– Contract requires 60% of interim carry to be escrowed until final accounting. Amount released now = 40% × $2.0m = $0.8m. Escrow balance = $1.2m.
– Final entitlement after fund close = $0.8m. Escrow is released to GP = $0.8m; remaining escrow $0.4m returned to LPs to satisfy the clawback. Net to GP = $0.8m + $0.8m = $
1.6m.
Practical takeaways for escrow and clawback design
– Purpose: Escrow (a holdback account) and clawbacks protect limited partners (LPs) from paying carried interest (carry) that later proves excessive once final accounting is done. They also reduce GP liquidity but shift long‑tail risk back to the LPs.
– Tradeoffs: Higher escrow percentages and longer release delays lower LP risk but increase friction for the general partner (GP). Consider the fund’s expected exit cadence, leverage, and expected tax timing when setting terms.
– Common escrow mechanics:
– Percentage holdback (e.g., 60% of interim carry).
– Time‑based release (e.g., escrow released after final audit or specified number of months after final close).
– Triggered release subject to waterfall reconciliation and clawback calculation.
– Clawback types (define): A clawback is a contractual right that requires the recipient to return excess carry.
– True-up clawback: GP returns any excess after final accounting.
– Escrow-first clawback: Escrowed funds are used before GP pays anything back.
– Netting vs. grossing: Netting considers prior distributions; grossing may require full repayment before re‑calculation.
Checklist for LPs when negotiating carry/escrow/clawback
– Waterfall basis: deal‑by‑deal, partially pooled, or whole‑fund? (Whole‑fund tends to favor LPs for uneven deal performance.)
– Escrow percentage and release schedule: what fraction and when is it released?
– Interest on held funds: does GP pay interest on escrowed funds or clawback amounts?
– Priority for returns: are escrowed returns credited to LPs for preferred return (hurdle) calculations?
– Dispute resolution: independent auditor, expert determination, or arbitration clause?
– Tax allocation: how are taxable items (income, gain, losses) allocated between LP and GP? Who bears tax shortfalls?
– Recordkeeping and audit rights: access to deals