What is Carried Interest?

Last Updated: 8 Sep 2025

BONUS! Don’t you love that word

Getting paid for your work is normal, but the feeling of being rewarded for your performance is unmatchable. In any profession, an extra incentive linked to performance serves a greater purpose. It motivates you to work harder and achieve the milestones for every stakeholder involved. ‘Bonus’ in a layman’s language can be called by different names in other lines of service.

Alternative investments are different from your traditional investments like stocks or gold. It goes a step higher with risk and returns. Investing in private equity, venture capital, hedge funds real estate, and commodities are alternative investment options. Incentives or profit-sharing for partners in the world of alternative investment is known as the carried interest. This article details what is a carried interest.This article details what is carried interest in private equity.

What is a Carried Interest?

Many newcomers to alternative assets start by asking, What is carried interest? In everyday conversation among fund professionals, people simply call it carried interest. In practice, carried interest private equity agreements have become the industry standard, yet the same economics appear in venture capital, real estate, and hedge funds.

Carried interest meaning refers to the additional compensation provided to general partners based on their performance rather than an initial investment in the fund. It is a common practice in private equity funds, hedge funds, and venture capitalist funds. In most countries, carried interest is treated as a long-term capital gain instead of ordinary income, thus providing tax benefits. Typically, carried interest is distributed after a certain period and defers taxes in the form of unrealized capital gain..

It is noteworthy that a general partner receives the carried interest irrespective of whether they invest anything from their pockets towards the purchase of the fund constituents. Carried interest is named so as the partners eligible for the profit share in private equity funds or hedge funds are allowed to reinvest the funds and carry it over the years until they cash out.

How does carried interest work?

Before delving into how carried interest works, let’s highlight how private equity funds or hedge funds operate. Typically, private equities and hedge funds are structured as partnerships with a few external investors, known as the limited partners. The private equity firms in charge of operating the business and managing several funds are called the general partners.

Usually, general managers or fund managers charge both a management fee and an incentive fee. The management fee is like a salary that general managers take home, a portion of the committed capital or the assets under management, irrespective of the fund’s performance. An incentive fee, called the carried interest, earned by the general partners after achieving the pre-determined rate of return, is called the hurdle rate.

There are instances where the general partners receive more than 20% of the total profit if it is distributed based on profits earned over time instead upon exiting the investment of the fund. To secure limited partners from this contingency, agreements and policies prohibit general partners from receiving the carried interest until the limited partners have received their capital back. An escrow account is set up for a portion of the carried interest and includes a clawback provision that forfeits the amount from general partners if the limited partners fail to receive their initial capital and 80% of the total profits.

Purpose of Carried Interest

• It turns fund managers into risk-sharing partners by giving them a performance-based slice of profits, ensuring decisions focus on long-term value rather than short-term fees.
• Because carry is earned only after investors recover capital and a preferred return, it embeds a protective hurdle while still rewarding exceptional skill and judgment.
• The mechanism substitutes for rigid salary ceilings in regulated firms, letting funds recruit top talent who are willing to postpone gratification in exchange for a potentially life-changing share of future gains.
• By tying remuneration to net performance after fees and expenses, carried interest incentivises cost discipline, discouraging wasteful overhead that would otherwise eat into the profit pool available for both managers and investors.
• It naturally lengthens investment horizons, because managers realise the biggest payouts come from patient compounding, thoughtful operational improvements, and disciplined exits carefully timed to strategic milestones rather than quarterly earnings optics.
• Carried interest is subordinate to the return of committed capital, so in downside scenarios the general partner earns nothing, reinforcing prudent risk management and aligning with limited partners’ instinctive aversion to capital impairment.
• Because carry crystallises only after an audit, it encourages transparent valuation policies, clean governance structures, and detailed investor reporting that would be less robust if remuneration were guaranteed regardless of outcome.
• The upside sharing mechanism allows limited partners to offer lower management fees, significantly reducing the cash drag on committed capital and thereby boosting internal rates of return without sacrificing manager motivation.
• Carry also provides a cushion against staff turnover, because junior team members understand that staying through the life of the fund is necessary to receive their allocated share once profits are distributed.
• Finally, the tax treatment of carry in many jurisdictions, though controversial, often results in a lower effective rate, which magnifies its incentive power without increasing the absolute cost to investors.

Key Restrictions of the Carried Interest

Carried interest is a vital concept for the fund managers operating alternative investments. While the general partners receive a carried interest, to ensure equality for the limited partners and other stakeholders involved, partnership and trust agreements put some restrictions on the release of a carried interest. Some of the forms of these restrictions are:

1. Hurdle rate:

   This is the minimum threshold return fund managers need to achieve to be eligible to receive a carried interest. The types of hurdle rates include:

   • Hard hurdle rate – Carried interest calculated on the amount above the hurdle rate.
   • Soft hurdle rate – Carried interest calculated on the whole profit amount only after achieving the hurdle rate.

2. High water mark:

   This clause prohibits crediting a carried interest till it reaches the previous highest mark. A high water mark protects investors from paying twice if the fund goes up the hurdle rate, falls below it, and then up again.

3. Clawbacks:

   This restriction tries to keep the general partners on their toes as it threatens the already received carried interest. In situations where the fund enjoys huge returns and pays out a part of carried interest only to see the performance plunge, the general partners have to give back some of the already received carried interest.

Hurdle rates, high water marks, and clawback provisions are specified in the partnership agreement.

How Does Taxation of Carried Interest Work?

Carried interest is not classified as general income tax instead if held for more than three years is treated as a long-term capital gain tax, usually 20%. However, this has been a controversial topic and is often criticized as a loophole that allows private equity managers to pay a lesser tax rate.

Example of carried interest calculations

Consider a buy-out fund with a ten-year life that raises ₹4,150 crore from limited partners (LPs). The general partner (GP) charges a 2% management fee on committed capital and accepts a 20% carry, subject to an 8% compounded preferred return. The fund buys five companies over three years, invests all the capital, and collects dividends. Eight years after inception, every asset is sold for ₹8,300 crore, and cumulative dividends total ₹415 crore. We now walk through the waterfall that returns money to investors and, eventually, to the GP’s carry pool.

Step 1 – Return of capital: LPs first recoup their ₹4,150 crore.

The first priority in the distribution waterfall is to return the original investment contributed by the limited partners (LPs). In this example, the LPs committed and invested ₹4,150 crore into the fund. Before any preferred return or profit-sharing is considered, this full amount must be repaid to the LPs out of the total cash flows (dividends plus sale proceeds). This ensures that investors recover their initial capital before the general partner (GP) receives any share of profits.

Step 2 – Preferred return:

Assuming all capital was drawn on day one, the 8% hurdle over eight years equals roughly ₹3,536 crore. Dividends plus sale proceeds come to ₹8,715 crore, so after capital repayment, ₹4,565 crore remain. Paying the preferred amount consumes ₹3,536 crore, leaving ₹1,029 crore for potential carry.

Step 3 – Catch-up:

The agreement states that once the hurdle is satisfied, the GP receives all subsequent distributions until its share equals 20% of cumulative profits. Profits are defined as cash returned above contributed capital, ₹4,565 crore here, so the GP must reach 20% of that, or ₹913 crore. Because the GP has not yet received any carry, the entire ₹1,029 crore excess flows to the GP until it hits the ₹913 crore target. That leaves ₹116 crore.

Step 4 – Split of remaining proceeds:

From this point on, every additional rupee is divided 80 / 20 between LPs and GP. The ₹116 crore balance is apportioned accordingly, giving LPs ₹93 crore and the GP ₹23 crore. Summing the catch-up and the final split, the GP ultimately pockets about ₹936 crore.

That figure equates to an effective 22.5% share of total profits, slightly above the headline 20%, because of the extra ₹23 crore received after the hurdle. LPs walk away with about ₹7,779 crore, comprising their capital, the preferred return, and their share of the upside, which yields a respectable internal rate of return of roughly 15% net of fees.

Had the fund underperformed, the waterfall would have stopped once capital and the hurdle were satisfied, leaving the GP with nothing. Conversely, a deal structure with no catch-up would have split the ₹1,029 crore directly, giving the GP only ₹206 crore. Such contrasts show how small contractual tweaks can dramatically reshape incentives, so limited partners review distribution provisions with a magnifying glass before committing capital.

Frequently Asked Questions

What is a carried interest?

Ans: A share of the profit earned by the general partners of a private equity fund, hedge fund, or venture capital on achieving the target return is known as the carried interest.

Who gets a carried interest?

Ans: General partners are eligible to receive a carried interest upon achieving the pre-determined threshold return levels.

Why is it called a “carried interest”?

Ans: Profit shares in a private equity fund or hedge fund are allowed to reinvest the funds and carry it over the years until they cash out. This concept of carrying forward is the reason to call it a carried interest.

Who are the general partners?

Ans: General partners are the authorized personnel of a hedge fund or a private equity fund that make business operations decisions. These partners are responsible to get returns from the fund.

What is a clawback provision?

Ans: The provision that allows the stakeholders to forfeit the carried interest distributed at the time of huge returns only to see the performance plunge is called the clawback provision.

How is carried interest taxed?

Ans: Carried interest is usually taxed as a long-term capital gain instead of a normal income providing tax benefits to the general partners.