“Carry, short for carried interest, is the share of a fund’s investment profits allocated to the general partner (GP) as performance compensation.” – Carried interest (carry)
Carried interest, commonly abbreviated as “carry,” represents a share of the profits earned from a fund’s investments that is allocated to the general partner (GP) as performance compensation1,6. This mechanism is fundamental to the structure of alternative investment funds, including private equity, venture capital, and hedge funds, serving as a primary incentive tool to align the interests of fund managers with those of their investors.
Core Structure and Function
In a typical private investment fund structure, a general partner (GP) raises capital from limited partners (LPs), who provide the investment capital4. The GP manages the fund, makes investment decisions, and oversees the portfolio companies. Rather than being compensated solely through management fees, the GP receives carried interest as a performance-based reward1. This arrangement ensures that the GP has “skin in the game”-a direct financial stake in maximising returns for all investors1.
Carried interest is only paid once the fund has returned investors’ capital and surpassed a minimum hurdle rate of return, which is typically between 8% and 10%1,3. This structure protects limited partners by ensuring that managers do not profit until investors have achieved their target returns. The specific terms governing carried interest allocation, including the hurdle rate and distribution waterfall (the order in which proceeds are distributed), are detailed in the fund’s investment agreement1.
Calculation and Typical Allocations
Carried interest is calculated as a percentage of the fund’s total profits above the hurdle rate. The formula is straightforward:
Carried Interest = Total Fund Profits × Performance Fee Percentage
For example, if a fund invests £100 million, achieves a final value of £140 million (exceeding an 8% hurdle rate), and the GP receives 20% of profits, the carried interest would be calculated as follows1:
- Total fund profits = £140 million ? £100 million = £40 million
- Carried interest = £40 million × 20% = £8 million
- Remaining profits to LPs = £32 million
In private equity, the standard carried interest allocation is typically 20% of profits to the GP and 80% to the LPs2. However, this varies depending on fund type, market conditions, and investor demand. Some prominent firms, such as Bain Capital and Providence Equity Partners, command “super carry” arrangements exceeding 20%6. Venture capital and hedge funds may have different structures, with venture capital funds often following similar 20% allocations8.
Relationship to Compensation and Wealth Generation
Carried interest serves as a primary source of long-term wealth generation for fund managers, distinct from their annual management fees (typically 2% of assets under management)4. The performance fee structure creates powerful incentives for GPs to identify high-quality investment opportunities, actively manage portfolio companies, and execute profitable exits. This alignment of interests is widely accepted by fund investors as assurance that GP objectives match their own1.
In real estate development, carried interest is also known as a “promoted interest” or “promote.” It compensates the developer (GP) for substantial risks undertaken during development and the period prior to property sale, whilst aligning the developer’s interests with those of equity investors7.
Tax Treatment
Carried interest has traditionally received favourable tax treatment. In the United States, it is typically taxed as long-term capital gains rather than ordinary income, provided the fund holds assets for more than three years2. This preferential treatment has made carried interest a subject of ongoing tax policy debate, with critics referring to it as the “carried interest loophole” or “Wall Street’s favourite tax break”6. The Tax Cuts and Jobs Act of 2017 extended the holding period requirement from one year to more than three years for long-term capital gains treatment, though most private equity funds hold assets for five years or longer, limiting the practical impact of this change2.
Key Theorist: Jensen and Meckling on Agency Alignment
Michael C. Jensen and William H. Meckling provided foundational theoretical work on the agency problem and incentive alignment that underpins the carried interest model. Their seminal 1976 paper, “Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure,” established the conceptual framework for understanding how performance-based compensation structures can mitigate conflicts between managers and investors.
Michael Jensen (1939-2019) was the Harvard Business School professor and leading organisational economist who spent much of his career examining how compensation structures influence managerial behaviour. Born in Rochester, New York, Jensen earned his PhD in economics from the University of Chicago and became renowned for his rigorous empirical and theoretical work on corporate governance. His research demonstrated that when managers have a direct financial stake in firm performance-what he termed “skin in the game”-they are incentivised to make decisions that maximise shareholder value rather than pursuing self-interested objectives1.
Jensen’s work was particularly influential in legitimising the private equity model during the 1980s and 1990s. He argued that the combination of management fees (to cover operational costs) and carried interest (to reward performance) created an optimal incentive structure. This framework became the intellectual foundation for the explosive growth of private equity and venture capital industries. Jensen’s research on leveraged buyouts and the role of debt in disciplining management further supported the theoretical case for carried interest as a mechanism to align interests in alternative investment structures.
William H. Meckling (1927-1998) was Jensen’s collaborator and a professor at the University of Rochester. Together, they developed agency theory-the economic framework explaining how principals (investors) can structure contracts with agents (managers) to minimise agency costs. Their work demonstrated mathematically that performance-based compensation reduces the divergence between managerial and investor interests. Meckling’s contributions emphasised the importance of monitoring and incentive alignment, principles that directly informed the design of carried interest arrangements in modern investment funds.
The Jensen-Meckling framework remains the dominant theoretical justification for carried interest. Their insight that managers with equity-like stakes in performance outcomes will behave differently than salaried employees has proven remarkably durable, shaping not only private equity and venture capital but also executive compensation practices across corporate America. Their work established that carried interest is not merely a compensation mechanism but a structural solution to a fundamental economic problem: ensuring that those making investment decisions bear the consequences of their choices.
References
1. https://www.moonfare.com/glossary/carried-interest
2. https://taxpolicycenter.org/briefing-book/what-carried-interest-and-should-it-be-taxed-capital-gain
3. https://www.firstcitizens.com/wealth/insights/planning/trust-planning-carried-interest-fund-partners
4. https://carta.com/learn/private-funds/management/carried-interest/
5. https://www.investmentcouncil.org/carried-interest-helps-american-businesses-grow-and-succeed/
6. https://en.wikipedia.org/wiki/Carried_interest
7. https://www.naiop.org/advocacy/additional-legislative-issues/carried-interest/
8. https://www.angellist.com/learn/carried-interest
