In private equity, carry — short for carried interest — is the share of a fund’s profits that goes to the fund manager as a performance reward, almost always set at 20% of net gains after investors have been paid back their capital plus a minimum return. The other 80% goes to the limited partners who put up the money. Carry is not a fee and not a salary. If the fund doesn’t clear its performance threshold, the manager gets none of it.
Carry Is Only Half of How Fund Managers Get Paid
Private equity compensation runs on a two-part structure known as “2 and 20.” The “2” is the annual management fee charged on committed capital, which covers salaries, offices, travel, and legal costs. The “20” is the carried interest.
The management fee is paid whether the fund makes money or loses it, and it’s taxed as ordinary income. Historically pegged at 2%, the average buyout fund management fee fell to 1.61% of assets in 2025, with most funds landing between 1.5% and 2.5% and often stepping the rate down after the initial investment period.1CNBC. Private Equity Management Fees Hit New Low in 2025
Carry is the other animal entirely. It’s contingent on performance, almost universally 20% of net realized gains, and — when certain conditions are met — taxed at the long-term capital gains rate rather than as ordinary income.2Investopedia. Understanding Carried Interest: Benefits, Workings, and Tax Implications That tax difference is why carry, not the management fee, is where fund managers build wealth.
How Carry Is Earned: The Distribution Waterfall
The fund’s Limited Partnership Agreement lays out a payment sequence called a waterfall. Each tier has to be satisfied before the next one activates, and the whole structure is designed so investors get paid first.
Return of Capital
The fund must return all invested capital to the limited partners before any profit-sharing calculation begins. If a $500 million fund deploys $400 million across its investments, investors get that $400 million back first. Nothing about carry exists until this happens.
Preferred Return
Next comes the preferred return, or hurdle rate: the minimum annual return investors must earn on their capital before the manager participates in profits at all. Most funds set the hurdle between 7% and 8% per year, cumulative and compounding. If the fund misses the hurdle in an early year, the shortfall carries forward.
On $400 million of deployed capital with an 8% hurdle, that’s roughly $32 million in the first year going to investors before the manager qualifies for a cent of carry. If profits fall short of the hurdle, every dollar goes to the limited partners.
The Catch-Up
Once the hurdle is cleared, a catch-up clause typically directs 100% of the next slice of profits to the manager. The point is to get the manager’s total share up to 20% of all profits, not just the profits above the hurdle.
An example: on $100 million of total fund profits where the preferred return consumed $24 million, the manager receives 100% of the next dollars until they hold $20 million, which is 20% of the whole $100 million pool. After that, additional profits split 80/20 between investors and the manager. Some funds skip catch-up or negotiate a partial catch-up; the effect is that the effective carry rate on total profits ends up somewhere between “20% of everything above the hurdle” and “20% of everything.”
When Carry Actually Gets Paid
Earning carry on paper and receiving cash are different events. The timing is governed by the distribution model the fund negotiates with its investors.
Deal-by-Deal
Under a deal-by-deal model, the manager collects carry after each successful exit, provided the gain on that deal exceeds its cost basis. Cash flows to the manager faster. But if the early deals do well and later deals disappoint, the manager may have collected carry that the fund as a whole never actually earned.
Whole-Fund
The whole-fund model is more conservative and is what most institutional investors want. The manager collects no carry until the entire fund has returned all committed capital plus the full preferred return. Payouts depend on the aggregate performance of the portfolio, not on any single deal. The Institutional Limited Partners Association recommends this “all-contributions-plus-preferred-return-back-first” approach.3Institutional Limited Partners Association (ILPA). ILPA Private Equity Principles
Hybrid With Escrow
Many funds compromise. The manager takes some carry on a deal-by-deal basis, but a meaningful portion is held in escrow until fund-level thresholds are hit. ILPA recommends escrowing at least 30% of carry distributions against potential clawback liabilities.3Institutional Limited Partners Association (ILPA). ILPA Private Equity Principles
The Clawback
The clawback is what makes deal-by-deal and hybrid structures workable for investors. It requires the manager to return previously distributed carry if, at the end of the fund’s life, the aggregate numbers don’t support what was already paid out. A final accounting at fund termination checks whether investors got their full capital and preferred return. If they didn’t, the manager writes a check back.
Clawback obligations often reach beyond the general partner entity to the individual principals who received the carry. Whether that personal exposure is several or joint and several is negotiated in the partnership agreement, and escrow accounts and personal guarantees are common backstops. For most institutional investors, the clawback is non-negotiable.
How Carry Is Taxed
The tax treatment is what makes carry so lucrative. When the conditions are met, carried interest is taxed as long-term capital gains rather than ordinary income. The 2026 top federal long-term capital gains rate is 20%, compared to a top ordinary rate of 37% for single filers with taxable income above $640,600.4Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Across millions of dollars in carry, that 17-point spread is enormous.
The Three-Year Holding Period
Section 1061 of the Internal Revenue Code, added by the Tax Cuts and Jobs Act, recharacterizes gains allocated through a carried interest as short-term capital gains (taxed at ordinary income rates) unless the underlying assets were held for more than three years.5Internal Revenue Service. Section 1061 Reporting Guidance FAQs That’s a longer holding period than the one-year rule that applies to other investors.
In practical terms: sell a portfolio company after two years and the manager’s carry from that deal is taxed at ordinary rates as high as 37%. Sell after three years and a day and it drops to 20%. The recharacterization rule also applies when a manager transfers a carried interest to a related person while the underlying assets have a holding period of three years or less.6Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services
The Net Investment Income Tax Adds 3.8%
On top of the capital gains rate, high-income fund managers owe an additional 3.8% Net Investment Income Tax on the lesser of their net investment income or the amount their modified adjusted gross income exceeds certain thresholds — $200,000 for single filers, $250,000 for married couples filing jointly, $125,000 for married filing separately.7Internal Revenue Service. Net Investment Income Tax Nearly every carry recipient clears those thresholds, so the effective top federal rate on qualifying carried interest is 23.8%.
The Political Question Isn’t Settled
Whether carry should receive capital gains treatment at all has been a running argument in tax policy. Critics call it disguised compensation for services. Defenders say the general partner is a real partner sharing in the risk and reward of capital appreciation, not just collecting a fee.
Bills to reclassify carry as ordinary income keep appearing. The Carried Interest Fairness Act of 2025, introduced in the Senate in February 2025, is the current iteration and remains in the Senate Finance Committee with no further action.8Congress.gov. S.445 – Carried Interest Fairness Act of 2025 The three-year holding period itself was a 2017 compromise that lengthened the requirement without eliminating the preferential rate. For now, the 20% rate on qualifying carry stands. Anyone building a career around this compensation structure should assume the rules can move.