What makes a private equity manager work late into the night or bet millions on the next company upstart? For most, it’s not just base salary or business bragging rights. It’s carried interest, the performance-based prize that’s sparked more controversy (and opportunity) than perhaps any other compensation in finance.
You might not realize it, but carried interest sits at the very heart of private equity. It’s the mechanism that turns fund managers from regular employees into true partners in the profits, ensuring they’re hungry for results that benefit you, the investor. Carried interest is deeply woven into private equity’s DNA, with roots stretching all the way back to the seafaring traders of the 1500s, and a footprint in nearly every major deal today.
Before you dive into your next investment, or simply want to demystify how the titans of Wall Street and Silicon Valley make their fortunes, it pays to understand carried interest, how it works, how it shapes incentives, and why it’s both lauded and debated in policy circles.
Here’s what you’ll discover in this article:
Imagine partnering with a ship’s captain in 16th century Europe. You supply the goods, they brave the journey, and—if the voyage is successful, the captain keeps a cut of the profits. Fast-forward to private equity today, and you’ll find the same model, just dressed in modern financial terms.
Carried interest, or “carry,” is the portion of investment profits that goes to a private equity fund’s general partners (GPs), the folks running the fund. Typically, it’s about 20% of the profits, though that number can flex. In exchange, GPs do the hard work: spotting opportunities, closing deals, and (hopefully) growing your money.
This arrangement has been around for centuries because it solves a simple problem: If you want someone to work as hard as possible to grow your wealth, give them a share of the upside. The more they earn for you, the more they make for themselves.
Let’s break it down with an example that’s easier to digest than an SEC filing. Suppose your private equity fund raises €500 million, agreeing to a “hurdle rate” of 8%. This means the fund has to deliver at least an 8% return to limited partners (LPs) like you before the managers see a dime in performance fees.
If, after a few years, the fund nets €100 million in profits, here’s what happens: The first €40 million goes to LPs to meet that 8% hurdle. Only after that do GPs get their shot at carried interest, claiming 20% of the remaining €60 million, or €12 million. The rest is split among investors.
This structure ensures that GPs only win if you, the investor, win first. It also means carried interest isn’t guaranteed; the performance bar is set deliberately high.
Here’s where theory meets reality: carried interest isn’t a side perk for fund managers—it’s often the main event. While annual management fees (typically around 2% of assets under management) keep the lights on, it’s carried interest that creates true wealth for GPs.
This model aligns interests. GPs are incentivized to find the best deals and grow your portfolio, because their payday is tied to the profits they generate. If you’ve ever wondered why big-name funds chase blockbuster acquisitions or pour resources into portfolio companies, it’s because that 20% carry can be worth tens or hundreds of millions.
In the U.S., the IRS has clarified that carried interest is not taxed upon grant, as long as certain “safe harbor” conditions are met. This means fund managers aren’t hit with taxes on hypothetical profits before those profits are realized, encouraging long-term thinking and risk-taking.
Here’s the lightning rod: carried interest is generally taxed as capital gains, not ordinary income. In the U.S., that means a top rate of about 20%, instead of up to 37% for regular income. For GPs, it’s a windfall; for policymakers and critics, it’s a sore spot.
Supporters argue that taxing carry as capital gains makes sense, since GPs are risking their own capital and time, just like any entrepreneur. Detractors point out that, in many cases, the money at risk is investor capital, not the managers’ own. Politicians periodically campaign to “close the carried interest loophole,” but the rule remains in place, benefiting top funds at Blackstone, KKR, and beyond.
If you’re an investor, this tax treatment helps attract talented managers and aligns incentives. If you’re a taxpayer, it’s worth asking whether the balance is fair.
Not all carried interest schemes are created equal. Some deals tweak the percentages based on how long a fund holds its investments. For example: a fund might promise managers 20% carry for a quick exit (say, within three years), but boost that to 25% if the investment stretches beyond that. The idea? Encourage patience when it’s strategically valuable, and reward true value creation over time.
You’ll find these arrangements tailored to fit the fund’s risk profile, sector focus, and market cycles. In boom times, managers might accept lower carry for a shot at larger fund sizes. In uncertain climates, higher percentages can help retain top talent.
Carried interest isn’t the only game in town. Some funds offer co-investment plans, a structure where participants (including managers or employees) invest their own money alongside limited partners. This entitles them to both a return of their invested capital and a share of the profits, tightening the alignment of interests even further.
Compare that with a conventional carried interest plan, where managers can share in the profits without putting much (or any) of their own cash at risk. The choice between the two can send a powerful signal to investors about the manager’s own “skin in the game.”
Funds from Carlyle to Sequoia routinely mix these structures, giving you, as an investor, more options to match your strategy or risk tolerance.
You now have a clearer lens on carried interest—the engine that powers private equity’s risk-taking and rewards. It’s not just an accounting term or a tax debate. It’s what transforms fund managers into entrepreneurs, driving them to hunt for returns that benefit both themselves and you, the investor. As you consider private equity for your own portfolio, or simply follow the stories of those who shape our financial landscape, remember to ask: are your interests, and theirs, truly aligned? And if not, what would you ask them to change?
Q: What is carried interest in private equity?
A: Carried interest, commonly called “carry,” is the share of investment profits allocated to private equity fund managers (general partners) as compensation for managing the fund. It typically represents 20% of the fund’s net profits and serves as a performance-based incentive.
Q: How does carried interest work for fund managers and investors?
A: Fund managers earn carried interest only after limited partners have received their initial investment back plus a minimum return. Once this threshold is met, general partners receive a percentage (usually 20%) of the additional profits.
Q: Why is carried interest important in private equity?
A: Carried interest aligns the interests of fund managers and investors by tying compensation to the fund’s performance. This incentivizes fund managers to maximize returns, benefiting both parties when investments succeed.
Q: How is carried interest taxed?
A: Carried interest is generally taxed as capital gains rather than ordinary income, resulting in lower tax rates for fund managers. This favorable tax treatment has been debated but remains a significant benefit in the industry.
Q: Are there different structures for carried interest arrangements?
A: Yes, carried interest can be structured based on fund performance or duration. For example, managers may receive a higher carried interest if the fund is held for longer periods. Additionally, co-investment plans require participants to invest capital, while carried interest plans distribute profits without a passive investment requirement.
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