Carried Interest
Carried interest is the agreed share of a fund's profits paid to the general partner after limited partners recover their invested capital plus any preferred return.
Reviewed by José Vasquéz, Managing Partner
The Institutional Limited Partners Association (ILPA) defines it as an agreed share of profits from realized investments that accrues to the general partner once investors recoup their original investment plus any defined hurdle rate (ILPA Principles 3.0, 2019).
Mechanism
Carried interest is distinct from the management fee, a recurring charge on fund capital that covers the manager's operating costs regardless of profits. ILPA Principles 3.0 say the fee should rest on reasonable expenses related to the normal operating costs of the fund.
The limited partnership agreement fixes the order in which proceeds are paid, the distribution waterfall. The ILPA Model LPA whole-of-fund term sheet sets four tiers: return of cumulative capital contributions; a preferred return; a catch-up to the general partner until it holds the agreed carry share of profits distributed so far; and a split of the remainder (whole-of-fund term sheet).
The whole-of-fund structure is commonly called the European waterfall and the deal-by-deal structure the American waterfall, labels that describe structure, not location (iCapital). ILPA Principles 3.0 call the whole-of-fund model best practice. The ILPA deal-by-deal term sheet requires return of capital for realized investments and aggregate unrealized losses before carry.
A profits interest is a partnership interest other than a capital interest, and the IRS generally does not treat its receipt for services as a taxable event (Rev. Proc. 2001-43, clarifying Rev. Proc. 93-27). Section 1061 applies to an applicable partnership interest, one held in connection with substantial services in a business that involves investing in or disposing of specified assets such as securities (26 U.S.C. 1061(c)). Net long-term capital gain on it is treated as short-term to the extent it exceeds the amount computed with three years in place of one (1061(a)).
Interests held by a corporation, other than an S corporation or a passive foreign investment company with a qualified electing fund election, are excluded, as are capital interests that give a right to share in partnership capital commensurate with the capital contributed (26 CFR 1.1061-3(b) and (c)). The holding period is the direct owner's in the asset sold (1.1061-4(b)(8)), and section 1231 gain, section 1256 gain and qualified dividends are excluded (1.1061-4(b)(7)).
A lookthrough rule applies when an interest held more than three years is itself sold, reaching gain attributable to underlying assets held three years or less if an unrelated non-service partner became obligated to contribute at least 5 percent of capital within the preceding three years, or if a transaction had a principal purpose of avoiding recharacterization (1.1061-4(b)(9)).
As of October 10, 2026, Public Law 119-21 (July 4, 2025) does not amend section 1061 (enrolled text), and a Kirkland & Ellis alert of July 14, 2025 states that the act does not change the tax treatment of carried interest (Kirkland Alert). The three-year period added by Public Law 115-97 therefore stands under the final regulations (T.D. 9945, 86 FR 5452). S.4330, the Ending the Carried Interest Loophole Act, introduced April 16, 2026, remained in the Senate Finance Committee with no further action recorded (Congress.gov).
Worked Example
Consider a hypothetical $100 million fund. Limited partners contribute $100 million at the start, and the fund makes one distribution of $200 million at the end of year five. Assume a compounded 8 percent preferred return, a 20 percent carry share, a full catch-up and an 80/20 split of the remainder. ILPA's 2021 report, using K&L Gates data, identifies an 8 percent hurdle as standard for 67 percent of funds sampled and 20 percent carry for 71 percent (What's Market in Fund Terms?); here they are arithmetic inputs only.
| Tier | Arithmetic | Limited partners | General partner |
|---|---|---|---|
| 1. Capital | $100.00 million | $100.00 million | $0 |
| 2. Preferred return | $100 million × (1.085 − 1) | $46.93 million | $0 |
| 3. Catch-up | $46.93 million × 0.20 ÷ 0.80 | $0 | $11.73 million |
| 4. Remainder | $41.33 million (100.00 − 46.93 − 11.73) | $33.07 million | $8.27 million |
| Total | $100 million profit | $180.00 million | $20.00 million |
The general partner's $20.00 million is 20 percent of the $100 million profit because the catch-up is full. Section 1061 reaches only that allocation: gain from a position sold after 30 months is long-term under a one-year test but not a three-year test, so it is generally recharacterized as short-term; after five years, none is.
Consider two $50 million investments, one sold for $100 million and one written off. A whole-of-fund waterfall pays no carry; a deal-by-deal waterfall without loss makeup pays $10 million, 20 percent of the $50 million gain, ignoring any preferred return.
What It Means for a Limited Partner
A limited partner reads carry through three terms. Waterfall: ILPA's 2021 report, using a Colmore data set of 695, shows 58 percent of North American funds on whole-of-fund terms and 42 percent on deal-by-deal or hybrid terms. Hurdle: ILPA Principles 3.0 favor a hard hurdle, so carry is based only on profits above the preferred return. Protection: the Principles recommend escrow of 30 percent or more of carry distributions and clawbacks, gross of tax, repaid within two years. Section 1061 itself bears on the general partner's after-tax result, not on limited partners' capital interests (26 U.S.C. 1061(c)(4)(B)).
In Life Sciences and Healthcare
BIO, Informa Pharma Intelligence and QLS Advisors put the likelihood of approval for a candidate entering Phase I at 7.9 percent over 2011 to 2020 transitions, and a Phase I asset needed an average of 10.5 years to reach approval (BIO). A deal-by-deal waterfall can pay carry on an early success before later write-offs are recognized, and ILPA states that an all-capital-back structure best minimizes clawback liabilities.
Governing Authority and Sources
- 26 U.S.C. 1061, added by Pub. L. 115-97, section 13309; 26 CFR 1.1061-1 through 1.1061-6; T.D. 9945, 86 FR 5452 (Jan. 19, 2021).
- ILPA Principles 3.0 (2019); ILPA Model LPA term sheets; ILPA, What's Market in Fund Terms? (2021).
- BIO, Clinical Development Success Rates 2011-2020; iCapital, Understanding Private Market Fund Distribution Waterfalls.
Frequently Asked Questions
What is carried interest?
Carried interest is the share of a fund's profits paid to the general partner as performance compensation, after limited partners recover contributed capital and any preferred return. ILPA describes it as an agreed share of profits from realized investments that accrues to the general partner.
How does carried interest work?
A distribution waterfall in the limited partnership agreement sets the order of payment. In a whole-of-fund structure, limited partners receive contributed capital and a preferred return, the general partner takes a catch-up, and the remainder is split at the agreed carry share. A deal-by-deal structure measures carry investment by investment.
How is carried interest calculated?
Carry is the agreed percentage of net profit after capital and any preferred return. ILPA Principles 3.0 call for calculation on net profits after fund-level expenses. In the $100 million example, 20 percent of the $100 million profit gives $20 million once a full catch-up applies.
Related Reference
This entry belongs to the growth equity thesis. Related entries: Distribution Waterfall, Multiple on Invested Capital and Key Person Provision.