Carried Interest

Carried interest, commonly called "carry," is a profit-sharing mechanism in venture capital funds that entitles general partners to a share of the fund's profits, typically around 20%, after the fund has returned capital to limited partners and met any hurdle rate requirements. ¹

The carried interest model aligns the incentives of fund managers (general partners) with those of their investors (limited partners). GPs only earn carry when the fund generates returns above a baseline threshold, motivating them to maximize investment performance rather than simply collecting management fees. ²

How Carried Interest Works

Venture capital funds operate as limited partnerships with two classes of partners. Limited partners (LPs) provide the capital but do not participate in day-to-day management, with their liability limited to their investment amount. General partners (GPs) manage the fund, make investment decisions, and advise portfolio companies. GP compensation comes primarily from management fees (typically 2% of committed capital annually) and carried interest (typically 20% of profits). ¹

The distribution follows a staged sequence called the distribution waterfall. First, LPs receive a return of their initial capital contributions. Second, LPs receive a preferred return, which is a predetermined rate signifying the minimum acceptable return before any carried interest is paid. Third, a catch-up tier allows GPs to receive a significant portion of profits until they reach their agreed percentage. Fourth, the remaining profits split between LPs and GPs, typically 80% to LPs and 20% as carry to GPs. ¹

Carried interest is typically structured as either European-style (whole fund) or American-style (deal-by-deal). In the European model, GPs receive carry only after returning all LP capital plus preferred returns across the entire portfolio. In the American model, GPs can receive carry on individual exits, allowing faster distribution but requiring clawback provisions if the overall fund underperforms. ³

Hurdle Rate

The hurdle rate is a benchmark return the fund must achieve before GPs can start receiving carried interest. This rate serves as a minimum acceptable return for LPs and ensures GPs are rewarded only after generating sufficient returns on investments. ¹

There are two types of hurdle rates. A hard hurdle means GPs earn carried interest only on returns exceeding the hurdle rate. A soft hurdle allows GPs to earn carried interest on all returns once the hurdle is met. In venture capital, the typical hurdle rate is around 7-8%, benchmarked against returns from less risky public market investments. ¹

Tax Treatment

Carried interest is taxed under the capital gains tax regime, which typically offers lower rates than ordinary income taxes. This treatment applies because carried interest is considered a return on investment rather than ordinary income, distributed after the fund achieves profits. To qualify for long-term capital gains rates, the assets generating the carried interest must be held for a minimum of three years. ²

Several U.S. senators have proposed legislation to eliminate this tax treatment, arguing it allows high-income investment managers to pay taxes at lower rates than ordinary workers. Supporters counter that the treatment appropriately aligns GP incentives with LP returns. ²

Clawbacks and Vesting

Clawbacks protect LPs by allowing them to reclaim carried interest paid to GPs if the fund does not meet overall performance benchmarks. If a GP receives carry from early wins but the fund ultimately underperforms, LPs can recover the overpaid amounts. ¹

Vesting ensures GPs earn their carried interest over time or upon meeting specific milestones rather than receiving it immediately. This mechanism keeps GPs motivated throughout the fund lifecycle, typically 10 years, rather than extracting value after a single exit. ¹

Example Calculation

For a fund with $100 million in capital that generates $200 million from exits: the profit equals $100 million after returning the $100 million in initial capital. If the GP carry rate is 20% with no hurdle, the GP receives $20 million in carried interest and LPs receive $180 million (their capital plus 80% of profits). ¹