Carried interest, or simply "carry," is one of the most important (and often misunderstood) aspects of fund economics. It’s the upside for GPs, the stuff that makes the headlines, but it’s not as simple as a straight percentage of proceeds.
Unlike management fees, which are predictable and paid regardless of performance, carry is only paid out to the investment team if the fund meets a pre-agreed minimum return, called the hurdle rate. In other words, no performance, no carry.
What is Carried Interest?
Carried interest is the share of a fund’s profits allocated to the fund employees for their role in managing investments and generating returns. In venture, this typically means that after returning capital to LPs, the GP takes 20% of the profits.
But there are a few key conditions:
1️⃣ The fund must meet a hurdle rate – LPs (Limited Partners) must first earn a minimum return before GPs can take carry.
2️⃣ Capital must be returned first – Before any profit split, LPs get their initial investment back.
3️⃣ Carried interest usually vests – GPs may earn their carry over time, not all at once.
The Hurdle Rate: What’s the Minimum Bar?
Not all venture funds can take carry right away. The hurdle rate ensures that LPs get a minimum acceptable return before GPs start profiting.
Hard hurdle: The GP earns carried interest only on returns that exceed the hurdle rate.
Soft hurdle: Once the hurdle rate is met, the GP earns carry on all returns, including those below the hurdle.
The VC Distribution Waterfall
The distribution waterfall determines how profits are split between LPs and GPs. It follows a specific sequence:
💸 Return of Capital – LPs get their original investment back first.
📊 Preferred Return (Hurdle Rate) – LPs receive a minimum return before any carry is paid.
🏃♂️ Catch-up – The GP receives a larger share of profits until they “catch up” to their entitled carry.
💰 Carried Interest (Profit Split) – Once the above steps are met, profits are split, usually 80% to LPs and 20% to GPs.
There are two main waterfall structures:
European (Whole Fund) Model: LPs must be fully repaid across the entire fund before GPs earn carry. This aligns long-term incentives. This is most common.
American (Deal-by-Deal) Model: GPs can take carry on individual successful deals, even if the overall fund hasn’t performed well. This can lead to earlier payouts but often includes clawback clauses to protect LPs if later deals underperform.
Let’s say an LP invests $5M in a fund with 20% carry. The fund does well, and that LP’s total payout is $100M.
First, the LP gets back their $5M principal.
The GP then takes 20% of the profits:
Profits = $100M - $5M = $95M
GP’s Share (20%) = $19M
LP’s Final Profit = $76M
Total return to the LP = $81M (original $5M + $76M in profit).
Carry is the payoff for top-tier GPs, but as always, it’s more complex than a originally meets the eye.
