Structuring Carried Interest and Waterfall Mechanics: Getting the Economics Right
Carried interest is the single most important economic term for a fund manager. It is the mechanism through which the GP participates in the upside of the fund, and how it is structured will determine the timing, amount, and tax treatment of the manager’s compensation over the life of the vehicle.
Despite that, carried interest provisions are often treated as standard form during fund formation, negotiated at a high level and then handed to counsel to "paper up." That approach leaves value on the table and creates disputes that surface years later, usually at the worst possible time: when real money is being distributed.
This article walks through the mechanics of carried interest and distribution waterfalls in private funds, with a focus on the structural decisions that drive economics and the negotiation points that matter most between GPs and LPs.
Topics covered:
• How Carried Interest Works: The Basic Mechanics
• Whole-Fund vs. Deal-by-Deal Waterfalls
• Preferred Return: Rate, Compounding, and Calculation Methodology
• The Catch-Up: Full vs. Partial and Why It Matters
• Clawback Obligations and GP Escrow Mechanics
• Carry Allocation Among the GP Team
• Tax Treatment of Carried Interest Under Current Law
• Conclusion
1. How Carried Interest Works: The Basic Mechanics
Carried interest is the GP’s share of the fund’s profits, paid after investors have received a return of their capital and a preferred return. The standard figure is 20% of profits, but the headline number alone tells you very little about what the GP will actually take home. The structure of the waterfall, the preferred return, the catch-up, the clawback, and whether carry is calculated on a whole-fund or deal-by-deal basis are what drive the real economics.
In a typical limited partnership structure, carried interest is not a fee. It is a profit allocation under the partnership agreement. This distinction matters for tax purposes. The GP does not receive a payment from the fund in exchange for services. Instead, the GP is allocated a disproportionate share of the fund’s profits through the distribution waterfall, which is why carried interest has historically been taxed at capital gains rates rather than ordinary income rates.
The GP usually receives its carry through a special allocation mechanism in the LPA. In some structures, the GP holds a separate carried interest class or a profits interest in the fund. In others, the carry flows through the GP entity and is then allocated among the principals and team members pursuant to a separate carry allocation agreement. The internal allocation is invisible to LPs but is one of the most important documents within the management company.
2. Whole-Fund vs. Deal-by-Deal Waterfalls
This is the structural choice that has the most direct impact on when the GP gets paid and how much risk the GP retains.
In a whole-fund (or "European") waterfall, carry is not paid until all invested capital across the entire fund has been returned to LPs and the preferred return has been satisfied on a cumulative basis. This means the GP does not receive carry until the fund as a whole is profitable. Losses on bad deals are netted against gains on good ones before any carry is distributed.
In a deal-by-deal (or "American") waterfall, carry is calculated and distributed on each investment as it is realized. If the fund sells a winner, the GP receives carry on that deal even if other investments in the portfolio are underwater. This structure pays the GP earlier and shifts more risk onto LPs, because the GP is collecting carry before the overall fund performance is known.
Institutional LPs overwhelmingly prefer whole-fund waterfalls. If you are raising from pension funds, endowments, or fund-of-funds, a whole-fund waterfall is the expected baseline. Deal-by-deal structures are more common in real estate funds, co-investment vehicles, and certain deal-by-deal platforms where the investment-level economics are more naturally self-contained.
Managers who use deal-by-deal waterfalls should expect LPs to require a strong clawback mechanism and may also face requests for an escrow or holdback on a portion of carry distributions to backstop the clawback obligation.
3. Preferred Return: Rate, Compounding, and Calculation Methodology
The preferred return (or "hurdle rate") is the minimum return LPs must receive before the GP earns any carried interest. The standard rate in PE and growth equity funds is 8% per annum, though this is not universal. Venture capital funds sometimes have no preferred return at all, particularly in earlier-vintage structures. Real estate and credit funds may use different hurdle rates depending on the risk profile of the strategy.
The details behind the 8% matter more than the headline:
• Compounding vs. simple. A compounding preferred return requires the fund to deliver 8% on a compounded annual basis before carry is triggered. A simple preferred return accrues 8% per year on a non-compounding basis. Compounding is more LP-friendly and is market standard for most buyout and PE funds.
• IRR-based vs. multiple-based. Some waterfalls use an IRR hurdle rather than a fixed preferred return, which accounts for the time value of money more precisely. In practice, an 8% compounding preferred return and an 8% IRR hurdle will produce similar results, but the IRR approach can create different outcomes when capital is drawn and returned unevenly.
• Calculation on contributed vs. committed capital. Most funds calculate the preferred return on contributed capital (money actually drawn from LPs), not on committed capital. This is an important distinction for LPs, because capital is typically drawn over the fund’s investment period rather than all at once.
Managers should model the interaction between the preferred return, the fund’s expected deployment pace, and the projected hold periods. An 8% compounding hurdle is easy to clear if you are deploying quickly and holding for five years. It is much harder to clear if deployment takes three years and the first exits do not come until year seven.
4. The Catch-Up: Full vs. Partial and Why It Matters
After LPs have received their preferred return, the catch-up tier is where the GP receives an accelerated share of distributions until it has "caught up" to its carried interest percentage of cumulative profits.
In a 100% catch-up (also called a "full" catch-up), the GP receives all distributions in the catch-up tier until it holds 20% of total profits distributed up to that point. Once catch-up is achieved, subsequent distributions revert to the residual split (typically 80/20).
In a partial catch-up, distributions in the catch-up tier are split between the GP and LPs at a negotiated ratio (for example, 60/40 or 80/20 in favor of the GP). A partial catch-up means it takes longer for the GP to reach its full 20% share of profits, which benefits LPs by keeping more capital in their hands for a longer period.
Full catch-ups are standard in buyout and PE funds. A partial catch-up or no catch-up at all may signal to the market that the manager accepted diluted terms, which can create issues when raising subsequent funds. That said, emerging managers sometimes agree to a partial catch-up to get a first fund over the line, with the understanding that terms will move toward market in Fund II.
5. Clawback Obligations and GP Escrow Mechanics
The clawback is the LP’s backstop against the risk that the GP receives more carry than it is entitled to on a cumulative basis. This is primarily a concern in deal-by-deal waterfalls, where carry is distributed before the fund’s overall performance is known, but whole-fund waterfalls include clawback provisions as well for situations where interim distributions overshoot.
A standard clawback provision requires the GP to return excess carry at the end of the fund’s life (or upon dissolution) so that the LP’s preferred return and return of capital are preserved on a fund-wide basis. The clawback is typically calculated on an after-tax basis, meaning the GP only has to return the net amount after accounting for taxes paid on the distributed carry.
LPs negotiate hard on clawback mechanics:
• Personal guarantees. Some LPs, particularly large institutional investors, will request that the individual principals of the GP personally guarantee the clawback obligation. This prevents the GP entity from being judgment-proof if it has already distributed carry to its members.
• Escrow or holdback. LPs may require the GP to escrow a portion of carry distributions (typically 20% to 30%) in a segregated account to backstop the clawback. This gives LPs a funded source of recovery rather than an unsecured claim against the GP.
• Interim clawback. Rather than waiting until fund dissolution, some LPAs include an interim true-up mechanism that tests the waterfall periodically and requires the GP to return excess carry if the fund’s overall performance has deteriorated.
Managers should understand that the clawback is not theoretical. Funds that pay carry early on the back of one or two strong exits and then experience losses in the rest of the portfolio can face real clawback exposure. Structuring the escrow and the personal guarantee at formation, rather than fighting about it later, is the better approach.
6. Carry Allocation Among the GP Team
How carry is divided among the GP’s principals and team members is an internal matter that LPs generally do not negotiate directly. But it is one of the most consequential decisions a manager makes, and it is documented in a separate carry allocation or profits interest agreement among the GP’s members.
Key considerations:
• Vesting. Most carry allocations vest over the fund’s life, typically three to five years. Unvested carry is forfeited if a team member departs. Some structures accelerate vesting upon a change of control or if the fund performs above a specified threshold.
• Forfeiture vs. reduction. When a team member leaves, does their unvested carry go back to the pool and get reallocated, or does it accrue to the remaining principals? The answer affects retention and incentive alignment for the rest of the team.
• Reserve pool. Many managers reserve 5% to 15% of the total carry pool for future hires and promotions. This gives the manager flexibility to bring in senior talent without diluting existing team members’ allocations excessively.
• Tax treatment of profits interests. Team members who receive carried interest through a profits interest (rather than a capital interest) in the GP generally do not have a taxable event at the time of grant, provided the profits interest is structured properly. The IRS has specific safe harbor requirements for profits interests, and getting this wrong can create unexpected tax liability for the recipient.
The carry allocation agreement is not a document to defer until the fund is up and running. It should be finalized at or before the first close. Disputes among team members about carry splits are one of the most common sources of internal conflict at fund managers, and they are far easier to resolve on paper before real money is at stake.
7. Tax Treatment of Carried Interest Under Current Law
Under current law, carried interest is generally eligible for long-term capital gains treatment, provided the fund’s underlying investments are held for more than three years. This three-year holding period requirement was introduced by the Tax Cuts and Jobs Act and applies to "applicable partnership interests," which includes most fund manager carry.
If the three-year holding period is not met, the carried interest income is recharacterized as short-term capital gain and taxed at ordinary income rates. This means the fund’s hold periods directly affect the GP’s tax bill, and managers should be thoughtful about how exit timing interacts with their carry economics.
A few additional tax points that fund managers should keep in mind:
• The three-year rule applies at the fund level, not the GP level. What matters is how long the fund held the investment, not how long the GP has been in the fund.
• State tax treatment of carried interest varies. Some states conform to the federal treatment; others apply their own rules. Managers operating across multiple jurisdictions should model state tax exposure as part of their carry projections.
• Carried interest has been a legislative target for years. While the current rules are settled, managers should build flexibility into their structures to accommodate potential changes in how carry is taxed.
Coordinate with tax counsel early in the fund formation process. The structure of the GP entity, the form of the carry allocation, and the distribution mechanics in the LPA all interact with the tax treatment of carried interest, and retrofitting these after the first close is expensive and disruptive.
Conclusion
Carried interest and waterfall mechanics are not areas where "standard" terms are good enough. The difference between a well-structured waterfall and a loosely drafted one can be millions of dollars over the life of a fund, and the negotiation dynamics shift materially depending on whether you are a first-time manager or raising your third fund.
Get the waterfall modeled before you finalize the LPA. Stress-test the preferred return against realistic deployment paces and hold periods. Negotiate the clawback and escrow mechanics with the understanding that they may actually be invoked. And document your internal carry allocation before the first dollar of carry accrues.
For advice on structuring your fund’s carried interest and distribution mechanics, or to benchmark your waterfall terms against current market practice, contact us. Learn more about our Fund Formation practice here.
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