Carried interest

Carried interest is a key aspect of compensation for many fund managers ( general partners) in the private markets. Because of the way carried interest is taxed, the concept has also become a political flashpoint in the U.S., often playing a central role in debates around taxation, wealth, and economic growth.  

What is carried interest?

Carried interest is the percentage of a private fund’s investment profits that the fund manager receives as compensation. Also referred to as “carry,” or a performance fee, carried interest is one of the primary ways that private equity funds, venture capital funds, and hedge funds get paid. 

Much like equity in a startup or other companies, funds use carried interest to compensate and incentivize their fund managers. Although fund managers typically also receive a salary and a share of management fees, carried interest is often their primary source of long-term wealth generation. 

For the purposes of taxation, carried interest is typically treated as a return on investment, rather than ordinary income, and is thus taxed as a capital gain. This can be beneficial for fund managers. The top tax rate in the U.S. for capital gains is 20%, compared to 37% for ordinary income, which means that any profits from carried interest are typically taxed at a lower rate than a standard salary or other types of income.  

How carried interest works

At a basic level, most private equity and venture capital funds have a similar structure: A fund manager (the GP) raises capital from limited partners (LPs), then uses that capital to acquire stakes in private companies. After a holding period—usually several years—the fund manager will try to sell those stakes for a profit. 

Fund managers return the bulk of any profits to their LPs. The portion that managers keep for themselves is called carried interest. The most common arrangement for carried interest is 80/20: returning 80% of the profits to the LPs and 20% of the profits to the fund's GP.

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Preferred Return (or a hurdle rate)

Before a GP collects its share of carried interest, it typically must first make its LPs whole by returning an amount of capital equal to their initial investment in the fund. Sometimes, the fund also has to meet a preferred return before it begins collecting carried interest, known as a hurdle rate. Note that hurdle rates are more common for PE funds, real estate funds, and hedge funds, but are not very common for VC funds.

A PE fund with a typical 8% preferred return, for instance, must give back to its LPs 108% of their initial investment before the fund manager begins to earn a portion as carried interest. If a fund clears that hurdle, the fund manager will then receive a set percentage of any additional profits—often around 20%. There’s typically no cap on carried interest, which means successful funds can be highly lucrative for fund managers.  

Carried interest structures and allocation

LPs who invest in a fund contractually agree what percentage of profit will go toward carried interest for the fund managers. Most private funds also charge their LPs a management fee, which supports the costs of running the management company and compensates the management company for the investment advice it provides. 

Historically, the most common fee structure for private funds is known as 2 and 20. In this structure, the LPs pay a management fee equivalent to 2% of all assets housed within the fund, and the fund manager receives 20% of all profits as a performance fee once the preferred return is met. 

Fee structures can vary significantly among private funds. Fund managers with strong track records may be able to collect a higher percentage of profits as carried interest (up to 30% in some cases), while emerging managers may choose to lower their share of carried interest in hopes of generating more interest among LPs. For most private funds, the portion of profits that goes toward carried interest will follow an 80/20 split.

Fee structures can also be impacted by macroeconomic factors. Fund managers may be able to command more carried interest for a fund raised during a strong overall economic environment than during a weak one. 

Any carried interest collected by a fund manager as an entity is often divided among multiple individuals. Investment firms typically divide carried interest from a fund among employees in a way that’s roughly proportional to the contributions those employees made to the fund’s success.

Distributions and waterfall structures

Carried interest can be allocated through either a European-style or American-style waterfall scenario. For any private fund, the Limited Partnership Agreement (LPA) will typically specify the precise manner in which any carried interest from the fund should be calculated and distributed. 

American-style waterfall

In an American-style waterfall, carried interest is applied on a deal-by-deal basis. This allows GPs to begin receiving carried interest earlier in the life of a fund, before the LPs have recouped their initial investment. 

At the time of each deal realization, the waterfall is evaluated to determine the amount of carry to distribute. This distribution is reassessed every time there’s a new realized deal. 

If some investments produce a profit and others lose money, it’s possible under an American-style waterfall for the GP to initially receive a larger share of carried interest than they are contractually obliged. To account for this potential gap, a fund with an American-style waterfall will typically include a clawback provision. 

European-style waterfall

In a European-style waterfall, carried interest is applied to the whole investment fund, rather than to each deal individually. This means that LPs must recover their initial investment and any hurdle rate must be met before the GP begins to receive any carried interest. 

This structure is often considered friendlier to LPs than an American-style waterfall, because it allows LPs to begin receiving returns more quickly and to avoid potentially complicated clawback distributions. In a European-style waterfall, it doesn’t matter which investments did well and which incurred losses. Instead, carried interest is based entirely on overall portfolio-level returns. 

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Clawback

A clawback is the process of reclaiming money or assets that were previously distributed, typically in cases of overpayment. In case of a clawback, the fund manager is contractually required to pay back the difference to LPs.

In the context of carried interest, a clawback is most likely to be triggered for a fund running an American-style waterfall (see above). If a fund initially over-distributes cash to the GP—i.e., if the GP receives a larger percentage of the profit than they are owed under the terms of the Limited Partnership Agreement—then some of those proceeds may be clawed back and returned to the LPs. 

Vesting

At some larger investment firms, carry can be subject to vesting for members of the GP entity, which may include individual fund managers and other employees, similar to how stock options vest for employees. 

For example, a partner at a fund might get a 10% carry allocation out of the total carry that the GP entity gets for a fund. The carry allocation will vest over a five-year holding period. If the partner leaves before that five years is up, they would only be entitled to the amount that has already vested.

Carried interest calculation

Whether a fund uses an American-style waterfall or a European-style waterfall, the end result is typically the same. After any necessary clawbacks, all of the fund’s profits should be divided between the GP and the LPs as defined in the fund’s LPA. 

The only difference is in when the math for dividing the profits is finalized. In an American-style waterfall, LPs may have to wait until the end of the fund’s lifespan for all profits to be properly distributed. In a European-style waterfall, LPs are at the front of the line to be paid back and less reliant on clawbacks. 

Carried interest taxation

Profits from carried interest are considered a return on investment for federal tax purposes. This means that carried interest can receive preferential capital gains tax treatment, similar to other investments like stocks or real estate, rather than being taxed as ordinary income.

For tax purposes, there are two types of capital gains. Short-term capital gains are taxed the same as ordinary income, with a top rate of 37%. Long-term capital gains are taxed at a lower rate, topping out at 20%. In both cases, the exact tax rate depends on the taxpayer’s income bracket. 

For carried interest, the holding period for an asset to qualify for the long-term capital gains tax rate is three years. Most private funds have a lifespan longer than three years. In most cases, then, a fund manager’s share of any carried interest is subject to the lower long-term capital gains tax rate. 

The fact that carried interest is taxed as a capital gain rather than compensation also means that it is not subject to the 15.3% self-employment tax that is paid by most employees and employers to help finance Medicare and Social Security.  

The “carried interest loophole”

Some see the current tax treatment for capital gains as a loophole that allows high-income investment managers to pay lower taxes than most other Americans. At various times, politicians on both sides of the aisle have pushed to “close” the loophole and increase the tax rate on capital gains.

Advocates for the current tax treatment argue that a lower rate on capital gains is a key incentive that drives investors to allocate capital into the private markets. They believe that increasing the tax rate on carried interest would stifle entrepreneurship and have a chilling effect on the sort of financial risk-taking that has historically fueled investment in the sorts of private companies that have been a key driver of U.S. economic growth for the past 75 years. 

Controversies and legislative efforts

In the U.S., taxation of carried interest in the U.S. has been a hot-button issue throughout much of the 21st century. The first major attempt at reform came in 2007, when Rep. Sander Lewin (D-MI) introduced H.R. 2834, which called specifically for carried interest received by “investment managers” to be taxed as ordinary income. 

Carried interest was a common talking point during the run-up to the 2012 presidential election due in large part to Mitt Romney’s background as a private equity investor at Bain Capital, where much of his income took the form of carried interest. Members of Congress introduced a handful of other bills in the first half of the 2010s aimed at changing the carried interest tax treatment, to no avail. 

During the 2016 presidential campaign, both Donald Trump and Hillary Clinton suggested that they would aim to increase the tax rate on carried interest if they were elected president. In a tax overhaul implemented in 2018 under the first Trump administration, the required holding period for an asset to qualify for long-term capital gains was increased from one year to three, although the tax rate remained unchanged.  

Early drafts of the Inflation Reduction Act of 2022 called for an increase in the capital gains tax rate, but that language was removed before the bill was ultimately passed. In 2024, legislators in both the Senate and the House of Representatives introduced new bills calling for capital gains to be taxed at the same rate as ordinary income. As part of an ongoing tax reform debate in Washington, D.C., in early 2025, the current carried interest tax treatment was preserved amid debate over ways to increase revenue.