**Carried interest (carry)** is the **share of fund profits** (typically 20%) paid to General Partners (GPs) after Limited Partners (LPs) receive their capital back plus a preferred return (hurdle). **Standard 2&20 structure**: 2% management fee on committed capital + 20% carry on profits above hurdle. **Example**: $100M fund, 3x returns ($300M), 8% hurdle. **Step 1**: LPs get $100M capital back. **Step 2**: LPs get 8% preferred return = $8M/year × 10 years = $80M (simplified). **Step 3**: Remaining profit = $300M - $100M - $80M = **$120M**. **Step 4**: GP carry = 20% × $120M = **$24M**, LPs get $96M. **Total GP compensation**: $24M carry + $20M management fees (2% × $100M × 10 years) = **$44M** (14.7% of total returns). **Catch-up provision**: After hurdle, GP gets 100% of next profits until reaching 80%/20% split (e.g., if LP got $8M hurdle, GP gets next $2M to catch up to 20% share of total $10M profit).

**American waterfall (deal-by-deal)**: Carry calculated on **each individual investment** as it exits.

GP receives carry immediately after each successful exit, even if other portfolio companies fail. **Pros** (GP): Faster carry payments, less clawback risk. **Cons** (LP): GP may receive carry early, then fund underperforms overall (requires clawback provision). **Example**: $100M fund, Deal A exits 5x ($50M → $250M profit), GP gets 20% × $250M = **$50M carry** immediately.

Later, Deal B fails ($50M → $0).

LPs lost $50M but GP keeps $50M carry (unless clawback). **European waterfall (whole-fund)**: Carry calculated on **entire fund performance** at fund liquidation.

GP only receives carry after **all** LPs receive capital + preferred return across entire portfolio. **Pros** (LP): True alignment, no clawback needed. **Cons** (GP): Delayed payments (10-12 years), higher risk. **Example**: Same deals, but GP gets nothing until fund closes. $250M profit - $50M loss = $200M net profit → GP carry = 20% × ($200M - $8M hurdle) = **$38.4M** (vs $50M under American). **Industry standard**: American for PE/VC (faster exits), European for hedge funds (annual performance).

**Hurdle rate (preferred return)** is the **minimum annualized return** LPs must receive before GP earns carry—protects LPs from underperformance. **Standard hurdles**: 6% (low, GP-friendly), 8% (market standard for PE/VC), 10% (high, LP-friendly for core real estate). **Calculation methods**: **Hard hurdle**: Carry only on profits **above** hurdle.

Example: $100M fund, 20% return ($20M profit), 8% hurdle ($8M).

Carry = 20% × ($20M - $8M) = **$2.4M**. **Soft hurdle**: Carry on **all profits** once hurdle is met (less common).

Example: Same scenario, carry = 20% × $20M = **$4M**. **IRR vs simple return**: Hurdle typically applied as **IRR** (time-adjusted return). $100M fund, 2x in 5 years = 14.9% IRR (exceeds 8% hurdle) → GP earns carry.

Same 2x in 10 years = 7.2% IRR (below 8%) → **no carry**. **Catch-up**: After LPs hit hurdle, GP gets 100% of next profits until reaching intended 80/20 split.

Example: LP got $108M (capital + 8% hurdle), GP gets next $2M to catch up, then 80/20 split resumes. **No hurdle risk**: GP earns carry from dollar one (rare, only in top-quartile funds).

**Carried interest tax treatment** (US): Taxed as **long-term capital gains** (20% federal + 3.8% NIIT = 23.8%) instead of ordinary income (up to 37% + 3.8% = 40.8%) if held >3 years. **Tax savings**: $10M carry → **$1.7M** lower tax (23.8% vs 40.8%). **2017 Tax Cuts and Jobs Act**: Extended holding period from 1 to **3 years** for LTCG treatment—if fund holds assets <3 years, carry taxed as ordinary income. **Requirements**: (1) Partnership interest in investment fund, (2) assets held >3 years, (3) GP provides "substantial services." **State taxes**: Additional 0-13.3% (CA 13.3%, NY 10.9%, TX/FL 0%). **Example**: CA GP, $10M carry → Federal 23.8% ($2.38M) + CA 13.3% ($1.33M) = **$3.71M** total tax (37.1% effective). **Controversy**: Critics call it a "loophole"—GPs perform services but pay investment tax rate. **Proposed changes**: Biden 2021 proposal to tax carry as ordinary income (not enacted). **Workaround**: Some GPs structure as C-corp GP (double taxation) or reinvest carry into fund (defer taxes). **Clawback tax risk**: If GP receives early carry (American waterfall) then must return it, **already paid taxes** on phantom income (requires escrow or insurance).

**Clawback** (giveback) requires GP to **return excess carry** received if fund underperforms overall—protects LPs in American waterfall deals. **Scenario**: GP receives early carry from successful exits, but later investments fail, causing fund to underperform hurdle. **Example**: $100M fund, Year 3 Deal A exits 5x → GP gets $10M carry (American waterfall).

Year 8, remaining deals fail → Total fund returns 1.5x ($150M) below 8% hurdle ($180M after 8 years).

GP must return $10M + interest. **Clawback amount**: Excess carry = (Carry received) - (Carry entitled at final fund IRR). **Escrow arrangement**: GPs withhold 10-20% of carry in escrow for 2-5 years post-exit to cover clawback. **Interest**: LPs earn hurdle rate (8%) on clawback amount during withholding period. **GP risk mitigation**: (1) European waterfall (no clawback needed), (2) 20% escrow reserve, (3) insurance products ($500k-2M premium per $100M carry), (4) negotiate cap (clawback limited to X% of total carry). **Tax issue**: GP already paid 23.8% tax on $10M carry ($2.38M), then must return $10M → net loss of $2.38M (can deduct as capital loss but may not offset fully). **Industry practice**: 80% of PE funds use American waterfall + clawback, 20% use European waterfall (no clawback but slower carry).

**Top-tier PE/VC carry compensation**: **Blackstone** (largest PE, $1T AUM): Co-founders earn $100M-500M+ annual carry (+ $10M-30M management fees). **Sequoia Capital** (VC): Partners share ~$200M-500M annual carry from exits (Airbnb, Stripe). **Benchmark VC**: 5 general partners, $1B+ carry pool from Uber/Snap exits → **$200M+/partner**. **Mid-tier funds** ($1-5B AUM): Partners earn $10M-50M carry per successful fund (2.5-3x target return). **Emerging managers** (<$500M first fund): $5M-15M carry if hit top-quartile (2.5x+ net IRR). **Carry as % of GP wealth**: PE partners' wealth 80-90% from carry, 10-20% from management fees + salary ($500k-2M base). **Industry carry statistics**: **2&20** standard (PE/VC), **1.5&17.5** (large buyout funds >$10B), **2.5&25** (seed/early VC), **1&10-15** (secondary funds). **Dilution**: Junior partners earn 0.5-5% carry allocation (vs 20-40% for founding partners). **Example dilution**: $100M fund, $20M total carry, 5 partners → each gets $4M, but founding partner may get $8M (40% allocation), junior gets $1M (5%). **Performance dispersion**: Top quartile funds (25%) generate 90% of industry carry—median fund barely hits hurdle (8% IRR) with minimal carry.