Carried Interest: Definition, Examples, and How It Works in Venture Funds
Understand how carried interest works, how it’s calculated, and why it matters in venture capital.
Table of Contents
In venture capital, carried interest, often called “carry,” is the share of a fund’s profits that the manager earns when investments perform well. Knowing how carry works helps both investors (limited partners, or LPs) and fund managers (general partners, or GPs) understand who gets paid, when, and why.
What is Carried Interest?
Carried interest is the portion of a private fund’s profits that the fund manager receives after investors are paid back their initial investment (and, in many cases, a minimum return). It’s essentially a performance-based incentive: instead of being paid simply for showing up, the GP earns carry only if the fund succeeds.
In most jurisdictions, carried interest is treated as investment income and is often taxed at the capital gains rate rather than as ordinary income. This structure gives GPs a performance-based incentive. They earn only when the fund delivers value to investors.
How Carried Interest Works in Practice
To illustrate, think of a fund with USD 20 million in committed capital that returns USD 80 million after 5 years (so USD 60 million in profit), with an 8% annual hurdle and 20% carry.
Step 1. Calculate the hurdle amount
Before any carry is paid, LPs must first receive their invested capital plus an 8% compounded annual return.
Using compound interest over five years: 20,000,000 × (1.08)⁵ = USD 29.39 million
So, the first USD 9.39 million in profits (beyond the original capital) goes to LPs to meet the hurdle.
Step 2. Determine total profits available for carry
The fund earns USD 60 million in profit, for total distributable proceeds of USD 80 million.
Step 3. Subtract capital and hurdle payments to LPs
LPs receive their USD 20 million capital and USD 9.39 million hurdle return, a total of USD 29.39 million.
Remaining profit for carry = USD 50.61 million
Step 4. Apply carried interest
The GP receives 20% carry on that profit:
0.20 × 50.61M = USD 10.12 million
LPs receive the remaining 80% (USD 40.49 million).
In total, LPs take home USD 69.88 million (capital + profits), while the GP earns USD 10.12 million in carried interest, receiving a reward only after investor returns are met.
The Crucial Role of the Hurdle Rate
Before GPs can collect carry, investors often must first achieve a minimum return, called a hurdle rate. Commonly set at around 8%, it ensures that GPs are rewarded only after LPs have earned a baseline level of return. Many venture funds, however, skip hurdle rates to maintain flexibility in early-stage investing.
How it Works
- LPs commit capital to the fund.
- The GP invests in startups.
- When exits occur, proceeds flow through a waterfall structure that dictates the order of distributions.
- LPs receive their capital (and possibly hurdle returns) first.
The remaining profits are split, typically with 80% allocated to LPs and 20% to the GP.
Alignment and the Clawback
A clawback provision protects LPs by requiring GPs to return excess carry if later fund performance declines or losses occur. This mechanism ensures long-term alignment, preventing early overpayment to managers before final fund outcomes are known.
Vesting of Carry
In larger funds, carried interest may vest over time, similar to employee stock options. A partner’s carry allocation (for example, 10% of the GP’s share) might vest over five years. If they leave early, only vested carry is retained.
Carried Interest vs. Management Fees
Feature | Management Fee | Carried Interest |
Purpose | Covers fund operations and salaries | Provides performance-based incentivization |
Based On | Assets under management (AUM) | Profits after LPs recover capital |
Timing | Paid annually, regardless of performance | Paid after profitable exits, via the waterfall |
Tax Treatment | Taxed as ordinary income | Often taxed as long-term capital gains |
Clawback | Not applicable | May require GP to repay excess carry |
Vesting | Not applicable | Can vest over multiple years |
Frequently Asked Questions:
Can carried interest be distributed before all investments are exited?
Yes. Some funds use deal-by-deal carry, allowing GPs to receive carry after each profitable exit instead of waiting until the fund fully closes.
Who decides the carried interest percentage?
It’s negotiated during fund formation and stated in the Limited Partnership Agreement (LPA), typically set around 20% but can range between 10–30% depending on fund strategy and track record.
Does carried interest apply to losses?
No. Carried interest only applies to profits after LPs recover their capital and any hurdle rate, ensuring GPs are rewarded only for positive fund performance.
Empower Your Fundraising with Auptimate
Whether you’re a fund manager or angel syndicate with Auptimate, we simplify SPV setup and management, helping you easily choose the right investment strategies. Our platform streamlines compliance, reporting, and investor onboarding so you can focus on your investment goals.
Get Started with Auptimate Today!
