Carried Interest

Carry is computed on realised proceeds at the fund level and only after prior claims in the distribution waterfall have been satisfied. Each realisation is allocated in sequence: return of contributed capital, including capital drawn to pay management fees and fund expenses, then the accrued preferred return on that capital, then the general partner catch-up, then the residual profit split. Because the earlier tiers absorb every distributed dollar until they are filled, a fund that returns barely more than invested capital pays no performance compensation at all, while a fund that doubles investor capital pays carry across the whole excess.

Accrual mechanics matter as much as the headline percentage. The preferred return typically compounds on drawn capital from the date of each capital call, so a slow exit increases the amount that must be paid to limited partners before the GP participates in anything.

A hurdle is either soft or hard. Under a soft hurdle with a full catch-up, the standard in buyout, the preferred return functions as a timing device rather than a permanent concession: once limited partners have received the hurdle, the GP takes all subsequent distributions until it holds twenty percent of total profits distributed, after which cash splits eighty-twenty. Under a hard hurdle there is no catch-up, and the GP earns carry only on gains above the hurdle rate, so its share of total profit is permanently below the stated carry rate.

Expressed in words, on a fund that turns one hundred of drawn capital into one hundred fifty, the first hundred returns capital, the next tranche pays the compounded preferred return, the catch-up tier pays the GP one quarter of that preferred amount, and the remaining profit is split eighty-twenty.

Because carry is paid as investments realise, a general partner can be overpaid early. Under a deal-by-deal, or American, waterfall, carry is tested transaction by transaction, so profitable early exits generate performance cash before later write-offs are known. Under a whole-of-fund, or European, waterfall, no carry is distributed until aggregate proceeds cover all contributed capital plus the preferred return. The European convention is materially more investor-friendly and dominant in European buyout funds.

Deal-by-deal structures are policed by a clawback: at liquidation the GP must repay carry received in excess of its contractual entitlement, usually calculated net of taxes already paid on it. Escrow accounts, interim true-ups and personal guarantees from partners reduce, but do not remove, the credit risk that the clawback proves difficult to collect.

Hedge funds charge an economically similar incentive fee, typically assessed annually on gains above a high-water mark and sometimes a hurdle, computed on marked-to-market rather than realised value. Real estate and infrastructure sponsors call the same economics a promote, often structured in multiple tiers that escalate the sponsor's share as successive IRR thresholds are met. Venture funds commonly retain a flat twenty or twenty-five percent carry with no preferred return, reflecting a long, highly skewed payoff distribution.

At Level I you should be able to walk distributions through a waterfall tier by tier, compute GP and LP shares under both full-catch-up and hard-hurdle terms, reconcile gross and net-of-fees IRR and multiple, and explain how timing conventions and clawbacks reallocate risk between the partners.