Carried Interest in Private Equity: How It Works

Behind the scenes, private equity fund managers don’t just earn fees—they also benefit from carried interest, a crucial element of private equity compensation.

However, if you’re new to PE investing, the concept of carried interest (or carry) might seem confusing. What is it? How does it work? And why is it such a hot topic in financial circles?

We’ll break it all down in simple terms, explaining how carried interest in private equity works, how it affects investors, and why it’s controversial. Even if private equity isn’t part of your portfolio, understanding carry can help you make more informed investment decisions. How? Read on to find out. 

What Is Carried Interest?

Carried interest, or simply carry, is the share of profits that private equity fund managers receive as part of their compensation. Unlike a salary or management fee, carried interest is performance-based, meaning fund managers only earn it if the fund generates profits.

Here’s a simple way to look at it:

Carried Interest = Fund Managers’ Performance Bonus It aligns the interests of general partners (GPs)—who manage the fund—with limited partners (LPs)—who provide the capital. The idea is simple: if the fund performs well, both investors and managers benefit.

How Much Carried Interest?

Typically, private equity firms receive 20% of a fund’s profits as carried interest, though the percentage can vary.

• First, LPs get their initial investment back - 100% goes to LPs;
• Next, LPs receive a preferred return (usually 8%) - again, 100% goes to LPs;
• After that, the remaining profits are split - 80% goes to LPs, and 20% goes to GPs.

This structure ensures that LPs—who risk their money—get their fair share before fund managers take their cut.

A Word About General Partners and Limited Partners

To understand how carried interest works, it helps to understand the roles of general partners (GPs) and limited partners (LPs). These two have different responsibilities, and their relationship determines how profits—and carried interest—are distributed.

Who Are General Partners?

General partners (GPs) are the fund managers who actively manage a private equity fund. They are responsible for raising capital, sourcing investments, managing the portfolio, and exiting investments to realise the fund's profits. 

GPs earn revenue through:

• Management fees - usually 1.5% – 2% of total assets under management (AUM).
• Carried interest – typically 20% of the fund’s profits after meeting investor return thresholds.

💡 Example: If a private equity firm raises a £500 million fund and charges a 2% management fee, it earns £10 million annually in fees—regardless of fund performance. However, carried interest is only earned if the investments generate profits above the agreed hurdle rate (usually 8%).

Limited Partners

Limited partners (LPs) are the investors who provide capital to the private equity fund. Unlike GPs, they do not manage investments directly but instead entrust their money to the GPs. Limited partners can be:

• Institutional investors like pension funds, insurance companies, and sovereign wealth funds;
• Family Offices & High-Net-Worth Individuals (HNWIs);
• University endowments are large educational institutions that invest to grow their long-term funds.

How Does Carry Work in Private Equity?

Carried interest in private equity isn’t distributed in a lump sum. Instead, profits flow through a structured "waterfall" model, ensuring that investors receive their capital and preferred returns before fund managers take their share of the profits.

Think of it as filling cups with water. The LPs’ cups must be full before any overflow reaches the GPs.

The Private Equity Carry Waterfall Explained

When a private equity fund realises profits (usually through a company sale or IPO), the money is distributed in a specific order:

1. Return of Capital: First, LPs get back their initial investment before profits are shared.
2. Preferred Return (Hurdle Rate): LPs receive a minimum return (often 8% annually) before GPs earn carry.
3. Carried Interest (Profit Split): Once these conditions are met, GPs take a share of the remaining profits—typically 20% carry.

🔑 Key takeaway: GPs only earn carried interest if the fund performs well. In other words, carry is a performance-based incentive rather than a guaranteed fee.

European-Style vs American-Style Waterfall

Private equity funds use two main types of waterfall structure—European and American:

Type	How It Works	Investor-Friendly?
European-Style Waterfall	LPs get back their capital + preferred return across the entire fund before GPs receive carry.	More favourable to LPs since GPs must ensure strong overall fund performance.
American-Style Waterfall	Profits are distributed on a deal-by-deal basis, meaning GPs can receive carry from successful exits before the whole fund matures.	Riskier for LPs as GPs may earn carry early, even if later deals underperform.

How the European-Style Carry Works

Let’s say a private equity fund raises £500 million and invests in multiple companies. Over time, it generates £100 million in realised profits from exits.

Here’s how a carried interest would be distributed:

1. Return of Capital: LPs are reimbursed their initial £500 million before profits are split.
2. Preferred Return: LPs receive an 8% hurdle rate on their investment (~£40 million).
3. Carried Interest: The remaining profits are now split 80/20:
• LPs receive 80% of what’s left (£32 million).
• GPs receive 20% carry (£8 million).

Under this model, GPs only earn carry if the entire fund performs well, protecting LPs from losses in some deals.

How the American-Style Carry Works

With an American waterfall, carry is earned per deal rather than at the fund level.

Let’s go through a simple example:

1. A private equity fund invests in 10 companies over 10 years.
2. It exits three investments early, making £50 million in profits.
3. Under an American-style model, the GPs immediately earn carry on these deals, even if the other seven investments are still unrealised.

This distribution format carries more risks for LPs. If the remaining seven investments lose money, LPs may not recover their total capital—but GPs would have already collected carry from early wins. Because of this, most LPs prefer the European-style waterfall, which only pays fund managers if the fund performs well. 

Which Carry Model Is Better?

That depends. Investors prefer the European waterfall, which ensures capital recovery before GP profits, making it a safer option.

Conversely, fund managers (GPs) may benefit more from the American waterfall, which provides faster payouts and rewards early success. 

Many larger institutional investors prefer European-style carry to prevent fund managers from getting paid too early. However, smaller private equity firms often favour the American model to reward themselves sooner.

How Is Carried Interest Taxed?

The topic of carried interest and taxation is pretty complicated. There is an ongoing debate about how it should be taxed. Since it is technically a form of compensation for fund managers, many argue it should be taxed as ordinary income. However, in most countries, it is treated as capital gains, and those are taxed at a much lower rate.

🧾 UK vs US Carry Taxation In the UK, carried interest is taxed at 32%, which is higher than regular capital gains but still lower than standard income tax. In the US, private equity carry qualifies for long-term capital gains tax (~20%), much lower than the top ordinary income tax rate (~37%).

Why is this controversial? Supporters argue that carried interest reflects long-term investment risk, similar to how stock investors are taxed on capital gains. 

Critics, on the other hand, say fund managers should not receive tax breaks on what is essentially performance-based compensation. This is commonly called the carried interest “loophole,” which some consider unfair because it allows high-income fund managers to pay lower taxes. 

Exploring Alternative Investments Beyond Private Equity

Private equity can be potentially highly rewarding, but it also requires high capital commitments and longer lock-up periods. As we’ve presented, it also involves complex fee structures, especially for beginner investors. 

That’s where alternative investments and Splint Invest come in, allowing investors to diversify their portfolios without the high barriers of private equity. 

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Yes, it’s that simple. So, if you’re looking to access alternative assets without high minimum investments or complex fee structures, we’re here to help. 

Check out our investment themes and join the growing community of investors looking for an alternative and more accessible way to diversify their portfolios.