Carried interest: The fund manager's performance incentive

Carried interest is a key aspect of compensation for many fund managers 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.

This article explains the mechanics of carried interest, covering the core concepts, distribution waterfall models, tax implications, and operational risks fund professionals manage.

What is carried interest?

Carried interest is the share of a private fund’s investment profits that a general partner (GP) or fund manager receives as compensation. Also referred to as carry, this performance-based compensation is one of the primary ways that fund managers get paid, and is common in private equity (PE), venture capital (VC), and hedge funds.

Much like equity in a startup or other companies, funds use carried interest to compensate and incentivize their fund managers by rewarding the GP for generating positive returns. 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. It is also distinct from any return the GP earns on their own capital invested in the fund.

This performance-based incentive structure is designed to align the interests of the fund manager with those of the investors, known as limited partners (LPs). The GP only earns carry after the fund’s investments perform well enough to meet specific thresholds. This ensures that the manager is incentivized to maximize fund returns for everyone involved.

How does carried interest work?

Most PE and VC funds have a similar structure: A fund manager (the GP) raises capital from investors (the 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.

A common model in PE and VC is the “two and twenty” fee structure, a common compensation agreement that traditionally consists of a 2% management fee and 20% carried interest. Under this structure, the GP charges a management fee (often around 2% of assets under management) and is entitled to a portion of the fund’s profits (often 20%) as carried interest. However, the GP doesn’t receive this carry right away. The fund must first achieve a minimum level of performance.

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.

The mechanics of carried interest are governed by the fund’s limited partnership agreement (LPA). This legal document is the definitive contract between the GP and the LPs and it outlines all the economic terms, including how and when carry is calculated and distributed. 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.

This video gives an overview of how venture capital funds are structured as part of Carta’s free VC 101 curriculum.

The role of the preferred return or hurdle rate

Before a GP can receive any carried interest, the fund must first deliver a minimum rate of return to its LPs. This minimum is known as the preferred return or hurdle rate. It acts as a threshold that ensures investors get their initial investment back, plus a predetermined return, before the GP shares in the profits.

For example, a PE fund with a typical 8% preferred return 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. There’s typically no cap on carried interest, which means successful funds can be highly lucrative for fund managers.

Note that hurdle rates are more common for PE funds, real estate funds, and hedge funds, but are not very common for VC funds.

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.

Modeling the distribution waterfall for carried interest

Carried interest can be allocated through either a European-style or American-style waterfall scenario. For any private fund, the LPA will typically specify the precise manner in which any carried interest from the fund should be calculated and distributed. Building and maintaining this waterfall model is one of the most critical and complex tasks for any fund manager.

Carta’s Waterfall Modeling automates these complex, customized calculations directly from your fund’s records. This removes the risk of spreadsheet errors and provides a single, reliable source of truth for all distributions.

American-style waterfall: Deal-by-deal carry

In an American-style waterfall, carried interest is calculated on a deal-by-deal basis. This structure allows the GP to begin receiving carried interest earlier in the life of a fund, before the LPs have recouped their initial investment, and can provide earlier liquidity for the GP.

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.

However, this model introduces significant administrative complexity. The fund manager must track each deal’s performance individually and manage distributions accordingly. 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 if later deals underperform.

European-style waterfall: Whole-fund carry

In contrast, a European-style waterfall calculates carried interest to the whole investment fund, rather than to each deal individually. Under this structure, all LPs must receive their entire capital contribution and any preferred return back before the GP is entitled to any carry. This approach is generally simpler to administer.

The European model is often considered more LP-friendly 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. It aligns the GP’s payout directly with the fund’s overall performance rather than the success of a few early deals.

The clawback: Reclaiming over-distributed carry

A clawback is a contractual provision in the LPA that obligates the GP to return previously distributed carry to the LPs, typically in cases of overpayment. 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 LPA—then some of those proceeds may be clawed back and returned to the LPs.

This is most often triggered in an American waterfall if early successful deals pay out carry, but later losses reduce the fund’s overall profit to a level where the GP was overpaid. The clawback ensures the GP’s final share of profits aligns with the LPA’s terms.

For fund managers, tracking this contingent liability is a major challenge in spreadsheets. It requires projecting future fund performance and maintaining perfect records of all distributions. An integrated fund administration software like Carta provides the data integrity and single source of truth needed to accurately track and manage these complex obligations, reducing significant risk.

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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.

How is carried interest taxed?

Carried interest has historically received favorable tax treatment, as it is considered a return on investment for federal tax purposes rather than ordinary income. This means it is generally taxed as a long-term capital gain rather than ordinary income, similar to other investments like stocks or real estate, provided the fund’s underlying assets meet a specific holding period.

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.

There are two capital gains rates. 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

The tax treatment of carried interest is a subject of ongoing political debate—often referred to as the “carried interest loophole”—with the Congressional Budget Office estimating that a change in tax treatment could raise an additional $12 billion over ten years.

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 PE 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 ordinary income rate. 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.

The operational reality of managing carried interest

For a fund’s chief financial officer (CFO), controller, or administrator, managing carried interest is a high-stakes responsibility. These operators have a fiduciary duty to execute the complex terms of the LPA with absolute precision. With a rebound in both PE acquisitions and exits increasing operational tempo, relying on manual processes like spreadsheets to model these calculations introduces significant, and escalating, risk.

This manual approach creates several pain points for fund managers. These challenges can undermine confidence and create compliance issues that demand an inordinate amount of time to resolve. As J.B. Handley, co-founder of PE firm Bochi Investments, puts it, “None of this administrative work makes me a better investor. My core skill is to find good companies to invest in. It’s not a good use of time to spend hours worrying about compliance or administration.”

• Interpretation risk: Translating dense legal language from the LPA into a functional spreadsheet model is a manual process that is highly prone to human error. A slight misinterpretation of a clause can have a cascading effect on all subsequent calculations.

• Calculation errors: A single broken formula or incorrect cell reference in a complex Excel waterfall can lead to misallocated profits and incorrect distributions.

• Lack of audit trail: Manual models lack a transparent, auditable history of all calculations and changes. This makes it difficult to respond to auditor or LP inquiries and creates serious compliance risks.

From manual calculations to strategic control

The complexities of carried interest, from waterfall modeling to tax compliance, highlight the risks of relying on manual, disconnected processes. Spreadsheets and email are not built to handle the fiduciary responsibilities of modern fund administration. They lack the controls, audit trails, and data integrity required to manage billions of dollars in capital.

Carta’s fund administration software provides a single, integrated platform that serves as the operational backbone for your firm, centralizing everything from fund accounting to distributions. Carta creates a single source of truth for all fund operations, streamlining the entire fund management process.

This gives fund professionals the control and accuracy needed to manage carried interest with confidence, freeing them to focus on high-value strategic work that drives fund performance.

To see how Carta can help you form, close, and administer your fund vehicles on a single platform, request a demo.

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Frequently asked questions about carried interest

What does a 20% carried interest mean?

This refers to the GP’s contractual right to a share of the fund’s profits, typically after LPs have received their initial investment back plus a preferred return.

How does carried interest differ from management fees?

Management fees are paid annually to cover the firm’s operating costs and management company, while carried interest is a performance fee paid from fund profits to reward successful investment outcomes.

How do management fees differ from carried interest in terms of taxation?

Management fees face higher tax rates than carried interest. Management fees are taxed as ordinary income (up to 37% federal income tax rate rate in the U.S.) when received by fund managers. Carried interest is taxed as long-term capital gains (up to 20% federal rate) if the fund’s investments are held more than three years.

Is carried interest the same as a profits interest?

Carried interest is the GP’s share of profits at the fund level, while a profits interest is a form of equity compensation granted to individuals within a company or GP entity, which is often structured as a limited liability company (LLC).

Does carried interest apply to all fund types?

The concept is common across PE, VC, and hedge funds, but specific terms like hurdle rates and waterfall structures can vary between fund types.