When people invest money in real estate, private equity, or venture capital, they often use investment partnerships. In these partnerships, there are two main groups:
- Limited Partners (LPs) – They put in most of the money.
- General Partners (GPs) – They manage the money and the investment.
To reward the General Partners for doing a good job, they receive a carried interest, which is a share of the profits. But before they get this carried interest, the Limited Partners usually get a preferred return. This setup makes sure that investors are rewarded first.
This article will explain in simple language what carried interest is, what preferred return means, and how both are calculated together. We’ll also look at an easy-to-follow example.
Contents
- 1 What is Carried Interest?
- 2 What is a Preferred Return?
- 3 Summary: How It Works
- 4 Key Terms
- 5 Why Preferred Return is Important
- 6 Simple Example of Carried Interest with Preferred Return
- 7 Waterfall Structure Explained
- 8 Real-Life Scenario
- 9 Clawback and GP Catch-Up
- 10 Common Carried Interest and Preferred Return Terms
- 11 Benefits of This Structure
- 12 Risks and Challenges
- 13 Carried Interest vs. Management Fee
- 14 Tax Note
- 15 Conclusion
- 16 Summary Table
What is Carried Interest?
Carried interest, also known as “carry,” is a share of profits that General Partners (GPs) receive after the investors (LPs) have been paid their promised return.
It is a performance-based reward for managing the investment well. Usually, the carried interest is 20% of the profits, but it can range from 10% to 30% depending on the deal.
Important Point: GPs don’t get carry from the beginning. They only receive it after LPs earn back their investment plus a preferred return.
What is a Preferred Return?
A preferred return (also called a hurdle rate) is the minimum return that Limited Partners must earn before the General Partners can receive any carried interest.
This preferred return is usually 8% annually, but it can be more or less depending on the agreement.
This protects the LPs and ensures they earn a basic return on their money first.
Summary: How It Works
- LPs invest money.
- GPs manage the investment.
- Profits are made after selling an asset or business.
- First, LPs get their invested capital back.
- Then, LPs get their preferred return (e.g., 8% per year).
- After that, any remaining profits are split—usually 80% to LPs and 20% to GPs as carried interest.
Key Terms
| Term | Meaning |
|---|---|
| Carried Interest | A portion of profits given to General Partners |
| Preferred Return | Minimum annual return given to Limited Partners before sharing profits |
| GP (General Partner) | The fund manager or sponsor |
| LP (Limited Partner) | The investor who puts in capital |
| Hurdle Rate | Another word for preferred return |
| IRR (Internal Rate of Return) | A way to measure annualized return of an investment |
Why Preferred Return is Important
Preferred return ensures that investors get paid first. It aligns the interests of both LPs and GPs:
- LPs are protected and motivated to invest.
- GPs are rewarded only if they perform well.
Without a preferred return, GPs could earn carried interest even if the investment didn’t do very well, which would be unfair to investors.
Simple Example of Carried Interest with Preferred Return
Let’s walk through a clear and simple example.
Basic Setup:
- LPs invest: $1,000,000
- Preferred Return: 8% annually
- Investment Period: 3 years
- Final Sale Value: $1,500,000
- Carried Interest: 20% after preferred return
Step-by-Step Calculation
Step 1: Return of Capital
LPs get their original $1,000,000 back.
Step 2: Calculate Preferred Return
An 8% preferred return on $1,000,000 over 3 years:
Use compound interest formula:
Preferred Return = $1,000,000 × [(1 + 0.08)³ – 1]
= $1,000,000 × [1.2597 – 1]
= $259,700
So LPs are entitled to:
- $1,000,000 (original capital)
- $259,700 (preferred return)
Total to LPs before carry: $1,259,700
Step 3: Remaining Profits
Total sale proceeds = $1,500,000
Total paid to LPs = $1,259,700
Remaining profit = $240,300
This is the profit split:
- GP (carry): 20% of $240,300 = $48,060
- LP: 80% of $240,300 = $192,240
Final Distribution:
- LP gets: $1,259,700 + $192,240 = $1,451,940
- GP gets: $48,060
Total = $1,500,000
Waterfall Structure Explained
A waterfall structure describes the order in which profits are distributed.
Common Waterfall Stages:
- Return of Capital – LPs get back what they invested.
- Preferred Return – LPs receive a fixed return (like 8%).
- Catch-Up (sometimes used) – GP gets 100% of profits until their share is “caught up.”
- Carried Interest Split – Any extra profit is split between LP and GP, usually 80/20.
Some deals include a catch-up clause. In that case, GPs may receive a bit more earlier, but that depends on the agreement.
Real-Life Scenario
Imagine a private equity fund managing a portfolio of companies. One company sells after 5 years with high returns. The LPs receive their full capital and preferred return. The GP receives carried interest of 20% of the remaining profits.
This rewards the GP for good performance, encourages smart investment, and ensures LPs are satisfied first.
Clawback and GP Catch-Up
What is a Clawback?
A clawback clause ensures that GPs don’t end up keeping too much if earlier profits look good, but later investments fail. If overpaid, GPs must return extra carry.
What is GP Catch-Up?
In some structures, after the LPs receive the preferred return, the GP gets 100% of profits until they’ve caught up to their 20% share.
Then, profits are split normally.
Common Carried Interest and Preferred Return Terms
| Feature | Typical Value |
|---|---|
| Carried Interest | 20% of profits |
| Preferred Return | 8% annually |
| GP Catch-Up | Optional (common in PE) |
| Clawback Provision | Yes (protects LPs) |
| Investment Period | 3–10 years |
| Waterfall Tiers | 2 to 4 levels |
Benefits of This Structure
For LPs:
- Safer investment
- Guaranteed priority in payments
- Fairness in profit sharing
For GPs:
- Performance reward
- Motivation to deliver good results
- Aligns interests with investors
Risks and Challenges
- If returns are low, GPs may not receive any carry.
- Complex calculations (need accounting or legal help)
- Disagreements over IRR or preferred return terms
- Need for clear contracts to avoid confusion
Carried Interest vs. Management Fee
Many funds also charge a management fee (like 2% per year) to cover costs. This is separate from carried interest.
- Management Fee = For operating the fund
- Carried Interest = For profit performance
Both are paid to the General Partner but under different rules.
Tax Note
In some countries like the U.S., carried interest may be taxed as capital gains (lower rate), not income. This has led to debates and changes in tax rules.
Always check with a tax advisor for your region.
Conclusion
Understanding how carried interest and preferred return work is important for anyone involved in private investments. These structures create fairness between investors (LPs) and managers (GPs).
- Preferred Return ensures investors are paid first.
- Carried Interest rewards the manager only after that.
It encourages responsible investing, protects capital, and aligns everyone’s goals.
Whether you’re a new investor or starting a fund, knowing how to calculate carried interest with preferred return will help you make smart decisions.
Summary Table
| Concept | Explanation |
|---|---|
| Carried Interest | Share of profits paid to GP after LPs are paid |
| Preferred Return | Minimum return LPs receive before GP earns carry |
| Usual Carry Rate | 20% |
| Preferred Return Rate | 8% annually |
| Profit Split (after pref) | 80% LP / 20% GP |
| Calculation Method | Return capital → Pay preferred → Split profits |
| Waterfall Structure | Steps defining payment priority |