We are often asked about the prevalent market options for structuring carried interest provisions in private equity and venture capital funds. In this post, we’ll speak of mainstream private equity and venture capital funds, so to speak. Terms differ in special situations, like co-investment funds, continuation funds, top-up funds, funds that are wholly or partially funds of funds, deal-by-deal special purpose vehicles (SPVs), pledge funds, secondary funds, continuation funds and other bespoke vehicles.
With that in mind, at a high level, there are several things to consider when structuring carried interest:
- What is the baseline percentage rate of gains that will apply as investment gains are allocated to the capital accounts of the general partners (GPs) and limited partners (LPs)? Is it 20% or a different percentage rate?
- How will the amount of investment gains be calculated when applying that percentage rate?
- Does the fund have a preferred return, and if so, how does the GP catch up (if at all) after that preferred return is satisfied?
- Does the fund have a performance hurdle that can increase the carried interest percentage from the baseline rate to a premium rate, and similarly, is there a catch-up?
- Sharing of gains into capital accounts aside, at what point will the fund manager be permitted to take distributions of cash or securities distributions constituting carried interest?
- If distributions are made to the GP or carried interest recipients in excess of the agreed amount, will there be a return obligation, commonly called a “clawback”?
- How should the fund agreement address the tax allocation rules applicable to carried interest (such as the general three-year holding period requirement for long term capital gain treatment and phantom taxable income)?
These questions are related, but they are not the same. A fund can have 20% carry with a European waterfall, no preferred return and a back-end clawback. Another fund can have 20% carry, an 8% preferred return, a 100% GP catch-up, deal-by-deal distributions, interim clawbacks and an escrow. Another fund can have premium carried interest that increases from 20% to 25% or 30% if the fund achieves specified return thresholds. Each structure allocates economics, timing, risk and tax consequences differently.
A note on terminology
Before turning to the market terms, it is worth pausing on terminology. In casual conversation, terms like “preferred return,” “hurdle,” “catch-up” and “premium carry” are sometimes used loosely or even interchangeably. That can create confusion, because they refer to different concepts. In this post, we will use the terms in the following way.
A preferred return is a minimum baseline return that the fund must generate for investors before any carried interest is payable to the GP. In many private equity funds, the preferred return is expressed as an annual percentage return, often historically around 8%, calculated on contributed capital or a similar base. The concept is that investors receive a threshold return before the GP participates in profits through carried interest.
Preferred returns are much more common in private equity than in venture capital. The reason is not merely historical convention. Private equity funds often invest in more mature businesses with revenue, profitability, cash flow, leverage capacity and more modelable exit assumptions. In that model, LPs often expect some return over a baseline or risk-free capital rate before the GP earns carry. Put differently, if a manager is investing in mature, revenue-generating companies and cannot underwrite to a minimum return, investors may reasonably ask why carry should be paid.
Venture capital, especially early-stage venture capital, is different. Early-stage venture-backed companies may not have profitability. They may not have revenue. In many cases, they may still be proving product-market fit, building a management team, developing a market or trying to create a category. The same kind of cash-flow modeling that may be relevant in a buyout or growth equity investment is often not available. For that reason, early-stage venture funds have generally not had preferred returns. Instead, they more commonly provide that investors receive a return of contributed capital before the GP takes carried interest distributions.
A hurdle, as we use the term in this post, is different. A hurdle is a superior investment return threshold that must be satisfied before carried interest increases above the baseline rate. For example, a fund may provide for 20% carried interest generally, but 25% carried interest if the fund returns more than 2.5x contributed capital, and 30% carried interest if the fund returns more than 3x contributed capital. That 2.5x or 3x threshold is not a preferred return in the sense described above; it is a performance hurdle for premium carry.
A catch-up is the mechanism used to move the economics to the agreed sharing ratio after a preferred return or hurdle has been satisfied. Catch-ups can be full and immediate, meaning the GP receives 100% of the next profits until the negotiated sharing ratio is reached, or they can be tapered, meaning the GP receives a higher-than-normal but less-than-100% share of the next profits until the same economic result is achieved. Catch-ups can apply after a preferred return, after a premium carry hurdle or both.
These distinctions matter. Two funds can each be described as having “20% carry,” but the economic result may be very different depending on whether there is a preferred return, whether premium carry is available above a hurdle, whether there is a catch-up and whether the catch-up is immediate or tapered.
The carry percentage
As to the percentage rate of gains that will apply, it remains widely accepted that the starting point is 20%. That is true across much of the private equity and venture capital market.
It is rare for a mainstream private equity or venture capital fund to assess a carried interest rate lower than 20%, though in some cases the rate may be higher. The surrounding economics may differ, because many private equity funds include a preferred return before carried interest is paid, while many early-stage venture capital funds do not. But the baseline carried interest percentage itself generally starts from the same market reference point: 20%.
Some exceptionally well-performing funds with superior investment track records or similar pedigree attributes assess flat headline rates of 25%, 30% or, in a few outlier cases in the industry, something higher. We call this “flat premium carry.” Flat premium carry exists in both private equity and venture capital, but in our experience, it is more commonly discussed in the venture capital market, particularly for highly sought-after managers with exceptional prior fund performance, very strong access to competitive investment opportunities or a differentiated strategy that investors believe is capacity constrained.
Flat premium carry is not, however, the main direction of travel for new fund negotiations. Many managers that have flat premium carry have had that term for a long time and are largely replicating an existing economic bargain with their investor base. From time to time, a new manager or a manager raising an early fund may obtain flat premium carry, but that is quite uncommon in today’s market. By contrast, the incidence of earned premium carry has been expanding.
Where there is potential for carried interest above 20%, the more common market approach is often “earned premium carry,” meaning that the higher carry percentage applies only if investment gains warrant it. This can be a useful compromise. It allows a manager to receive enhanced economics if the fund substantially outperforms, while giving investors comfort that the enhanced economics are paid only after investors receive the benefit of that outperformance.
LPs may not merely accept this structure; in some cases, they may affirmatively appreciate it. Earned premium carry can create alignment. The manager is rewarded for exceptional performance, but only if investors first receive exceptional results. Flat premium carry does not work the same way. A flat 25% or 30% carry rate gives the manager enhanced economics from the first dollar of profit, whether the fund modestly outperforms, dramatically outperforms or merely clears the basic return-of-capital threshold. Earned premium carry, by contrast, asks the manager to earn the enhanced economics through actual fund performance.
In Cooley’s 2026 survey of private fund terms, 34% of funds reviewed had some form of premium carry. That does not mean premium carry is the default. It is not. But it does mean that premium carry is a meaningful and recurring part of current fund terms, particularly for managers with strong performance, strong investor demand or a strategy where investors are willing to share more of the upside if the fund substantially outperforms.
In an earned premium carry model, investment gains are often measured by reference to cash-on-cash return thresholds, such as 2x, 2.5x or 3x contributed capital. In a minority of cases, the calculation may use thresholds based on internal rate of return (IRR) or a combination of IRR and multiple-of-capital thresholds. Cash-on-cash tests are often simpler and more intuitive in venture capital, where fund returns can be highly nonlinear and driven by a small number of large winners. IRR-based tests are more common in some private equity contexts, where investment timing, leverage, distributions and current yield may be more central to the investor’s underwriting. That said, some private equity funds with premium carry hurdles use cash-on-cash multiple thresholds as well, particularly where the parties want a simpler test that is less sensitive to interim timing and calculation conventions.
The higher carried interest rate may apply only prospectively after the relevant condition is satisfied. For example, the manager may receive 20% carry until the fund reaches a specified return threshold and then 25% carry on gains above that threshold. More commonly, however, the higher rate applies on a retroactive basis through a catch-up to the fund manager. In that model, once the condition is satisfied, the manager may receive 100% of the next gains until it has received the higher percentage of gains on a from-inception basis. Sometimes the catch-up is softened by providing that, instead of receiving 100% of the next gains, the manager receives a lesser but still elevated percentage, such as 50% of the next gains, until the intended sharing ratio is achieved.
Sometimes there may be multiple tiers. For example, a fund might provide that the manager receives 20% of gains until investors have received a 2x cash-on-cash return, 25% of gains once the fund has achieved a 2x return, and 30% of gains once the fund has achieved a 3x return, with catch-ups applying at each tier. In these models, the precise drafting matters a great deal. The agreement needs to specify whether the test is based on contributed capital, aggregate commitments, realized proceeds, unrealized value, net or gross proceeds, expenses, recycling, or reserves, and the timing of measurement.
Cash-on-cash measurements are often based on contributed capital rather than committed capital. This means that as more capital is drawn, a manager that previously satisfied a 2x condition may no longer be in that position. Where this is the case, the manager will usually have to defer the collection of incremental carried interest until the applicable condition is again satisfied.
Preferred returns
The preferred return is one of the more important areas where private equity and venture capital often diverge.
In many private equity funds, particularly buyout, growth equity and other strategies involving more mature portfolio companies, investors expect a preferred return before the GP receives carried interest. The classic formulation is an annual preferred return, often around 8%, followed by a GP catch-up and then the agreed sharing ratio, often 80/20. The exact number and calculation vary by strategy, manager leverage, investor base and market conditions, but the concept is familiar: Investors receive a minimum return on contributed capital before the GP begins to participate meaningfully in profits.
In early-stage venture capital, preferred returns are much less common. There are historical and practical reasons for this. Venture capital funds often have long J-curves, little or no current yield, unpredictable exit timing and returns that may be driven by a small number of very large outcomes. A preferred return can become more of an accounting hurdle than meaningful investor protection in that setting, and it can create pressure against the long-duration nature of venture investing. For that reason, mainstream early-stage venture capital funds often use a return-of-contributed-capital-before-carry model rather than an annual preferred return.
That said, the line is not absolute. Later-stage venture, growth equity and hybrid venture-growth funds may include preferred return concepts more frequently than seed or early-stage venture funds. Similarly, some private equity funds, especially funds with very strong demand or specialized strategies, may deviate from the classic preferred return formulation. The appropriate answer depends on strategy, investor expectations and the overall economic bargain.
Where a preferred return exists, the catch-up mechanics are important. A 100% GP catch-up means that after investors receive their preferred return, the GP receives all or nearly all of the next distributions until the GP has caught up to the agreed carried interest percentage. This is common and often understood by investors. But it can be surprising if not explained clearly, because there may be a period in which distributions go disproportionately to the GP even though the headline carry rate is 20%. That is not a deviation from the 20% carry rate; it is the mechanism by which the waterfall gets to the negotiated sharing ratio after the preferred return has been paid.
What gains are subject to carry?
The second general issue in structuring carried interest is determining the amount of investment gains used when applying the agreed carry percentage.
There are two general approaches. In some funds, the carried interest percentage is applied against total investment gains in the portfolio net of total investment losses, without taking into account fund expenses. In other funds, fund expenses, in addition to investment losses, are debited against total investment gains in determining the relevant amount against which carried interest is assessed.
Consider a simple example, ignoring the GP commitment. Assume a $100 million fund invests $80 million and spends $20 million on management fees and other expenses. Assume the $80 million of investment doubles and becomes $160 million. The fund has $80 million of gross investment gain. In a gross carry model, the GP receives 20% of the $80 million of gross investment gain, or $16 million. In a net carry model, the $20 million of fees and expenses is subtracted from the $80 million of gross investment gain, resulting in $60 million of net gain. The GP then receives 20% of $60 million, or $12 million.
Each model is associated with numerous funds in the marketplace. Neither model is exclusive. The first model is more favorable to the manager because carry is calculated on investment performance without reducing the base for fund expenses. The second model is more favorable to investors because expenses reduce the pool of profits on which carry is paid. The commercial answer may depend on the overall fee level, fund size, expense load, organizational expense cap, expected investment strategy and whether expenses are expected to be unusually high.
This issue can be more significant in smaller funds, funds with meaningful broken-deal expenses, funds investing internationally, funds with significant regulatory or tax structuring costs, or funds that expect to use parallel vehicles, alternative investment vehicles or blockers. In a very large fund with ordinary expenses, the difference may be less central to the economic deal. In a smaller or more complex fund, it can matter materially.
Timing of carry distributions: European and American waterfalls
The next issue is when the fund manager can take cash or securities distributions representing carried interest. This is commonly described by reference to the fund’s “waterfall,” meaning the sequence in which distributions are made among LPs and the GP.
Two terms are commonly used in this context. A European waterfall, also called a whole-fund waterfall, generally means that the fund must first return contributed capital before the GP may start to receive carried interest distributions. An American waterfall, also called a deal-by-deal waterfall, generally means that the GP may receive carried interest after a realized investment if certain conditions are satisfied (occasionally measured by examining the carrying value of the remaining portfolio against its cost basis, though there are other methods), even if the fund has not yet returned all contributed capital across the whole portfolio.
The difference is mostly about timing and overdistribution risk. A European waterfall delays carry distributions until the fund has more clearly produced whole-fund profits. An American waterfall may allow earlier carry distributions, but creates a greater possibility that the GP receives carry on early winners before later investments underperform or fail.
It is important to distinguish the accrual of carried interest to the GP’s carried interest capital account from the right to receive distributions. The allocation of profits to the GP on an accounting basis begins at inception of the fund’s life (which is necessary, because if deferred there is a risk there will not be sufficient allocable gain to fill up the GP’s capital account to agreed levels later). But the right to take cash or securities out of the fund on a distributions basis is effectively always delayed until some condition is satisfied.
Consider a $100 million fund that draws $5 million for its first investment and sells that investment relatively quickly for $25 million. If the fund has a 20% carried interest rate, there is $4 million of carry on the $20 million gain. But the early winner does not mean the fund will ultimately return all contributed capital or generate whole-fund profits. If the fund later draws the remaining $95 million and the later investments perform poorly, the manager may have received more than it was entitled to retain on a whole-fund basis.
That is the core overdistribution risk. Since carried interest is usually assessed on a whole-fund basis, investors – and many managers, especially those who have lived through the pain of asking a team to return carry distributions they may have already spent – may want to defer carry distributions until there is greater confidence that the carry will not become an overdistribution.
The most prevalent method of delay is a European waterfall. In the same example, assume that by the time the $25 million in exit proceeds are received, the fund has called $30 million of capital for other investments and expenses. In a European waterfall model, no carried interest distribution is permitted yet, because the $25 million is not sufficient to return the $30 million contributed.
This approach is very common in the market. In Cooley’s 2026 survey of private fund terms, approximately 90% of funds reviewed used a European waterfall. The remaining funds used some form of deal-by-deal or American-style waterfall. The prevalence of European waterfalls is especially notable in venture capital, but whole-fund distribution protections are also common in many private equity funds.
If the fund instead uses an American waterfall, the manager may be permitted to receive carried interest on the realized investment if the applicable deal-level test is satisfied. Deal-by-deal waterfalls are more common in parts of the private equity market than in early-stage venture capital, although they are not unknown in venture and are often modified by safeguards, which may include net asset value (NAV) tests, escrow arrangements, interim clawbacks, reserves or other mechanisms. For example, a fund might permit carried interest distributions on a realized deal only if, after giving effect to the proposed distribution, the remaining portfolio has a value of at least 125% of cost, or if the fund would not be in a hypothetical clawback position based on the then-current value of remaining assets.
The important point is that venture capital funds, because they often make many investments over a long period and may experience a small number of highly material winners, commonly use whole-fund distribution protections. Private equity funds, particularly buyout and growth equity funds, may be more likely to negotiate deal-by-deal distribution models, but with more robust clawback and security architecture. Neither model is inherently right or wrong. The question is whether the timing of carry distributions matches the strategy, investor expectations and overdistribution risk.
Tax distributions and phantom income
In the US and some other tax regimes, the carried interest recipients may be taxed not on cash distributions, but on allocations of taxable income or gain. This is sometimes referred to as “phantom income” and creates a practical problem. A manager may be allocated taxable income before the manager is permitted to take regular carried interest distributions under the waterfall.
Most fund agreements address this issue through tax distributions. A tax distribution provision permits distributions to the GP or carried interest recipients in an amount intended to help pay taxes on taxable income or gain allocated to them, even if regular carried interest distributions are otherwise delayed.
Tax distributions are usually advances against future amounts that the manager would otherwise be entitled to receive. They are not intended to give the manager more economics, but rather, are used to avoid a cash flow mismatch between tax liability and distribution timing.
The details matter. Fund agreements need to determine the assumed tax rate, whether state and local taxes are included, whether the rate is based on the highest marginal rate applicable to an individual in a specified jurisdiction, whether prior losses or deductions are taken into account, whether tax distributions are grossed up and how tax distributions are treated for clawback purposes. The rate may be expressed as a flat rate agreed on at inception (35 – 45% is common), or language may be used to describe it with reference to the highest marginal rates, as they may change over time.
Tax distributions can become especially important in a period of early realizations, securities distributions, recycling, taxable stock-for-stock transactions or carried interest waiver planning under Section 1061. They should not be treated as boilerplate.
The three-year carried interest rule under Section 1061
The most important tax development since the original carried interest primer is the now-familiar three-year holding period rule under Section 1061.
Before the Tax Cuts and Jobs Act (TCJA), both carried interest holders and capital interest holders generally could receive long-term capital gain treatment on gains from the sale of capital assets held for more than one year. The TCJA added Section 1061, effective for taxable years beginning after December 31, 2017. Section 1061 generally recharacterizes certain net long-term capital gains allocated with respect to an applicable partnership interest as short-term capital gains, unless the relevant capital asset has been held for more than three years. The IRS describes the rule as requiring that a capital asset be held for more than three years for gain allocated with respect to certain carried interests to avoid recharacterization as short-term capital gain.
Short-term capital gain is generally taxed to individuals at ordinary income rates. As a result, for US individual carry recipients, the difference can be significant. Long-term capital gain may be taxed at preferential rates, while short-term capital gain may be taxed at ordinary rates, potentially as high as 37% federally, plus the 3.8% net investment income tax where applicable.
The Treasury Department and IRS issued final regulations under Section 1061 in January 2021. The final regulations provide detailed rules on applicable partnership interests, applicable trades or businesses, holding periods, capital interest exceptions, transfers and reporting. The current rule was not changed by the 2025 tax legislation commonly referred to as the One Big Beautiful Bill Act; Cooley’s 2025 tax alert notes that the final legislation did not change the tax treatment of carried interest, although Congress had considered proposals to further limit long-term capital gains treatment.
For many private equity and venture capital funds, the three-year rule will not affect most carried interest gains. A substantial portion of private fund investments are held longer than three years. In venture capital, especially early-stage venture capital, the typical successful portfolio company is often held well beyond three years. In private equity, many buyout and growth equity investments are also held for periods exceeding three years.
But the issue is real.
It may sound somewhat counterintuitive, particularly to managers accustomed to long fund lives and multiyear holding periods, but in the current fast-paced deal environment we are seeing a not insignificant number of successful exits inside three years. In some cases, those exits are excellent business outcomes. The problem is not commercial. The problem is tax. A highly successful realization can produce an unexpectedly bad carried interest tax result if the relevant holding period is three years or less.
In venture capital, a short holding period can arise in late-stage investments, top-up funds, opportunity funds, SPVs, pre-initial public offering (IPO) investments, secondary purchases, bridge rounds before a sale, or simply a company that exits unusually quickly. In private equity, the issue can arise in fast buy-and-build strategies, continuation transactions, recapitalizations, add-on acquisitions, partial exits, minority growth investments, secondaries, structured transactions and investments sold more quickly than expected.
The issue can also arise because of transaction structure. For example, a fund may hold stock in a private company for more than three years, but then exchange that stock in a taxable or partially taxable transaction for stock of a public acquirer, or for securities whose holding period is measured from the time of the transaction. If the fund later sells those new securities before the relevant holding period is satisfied, the manager may have a less favorable Section 1061 result than expected. These rules are technical, and managers should involve tax counsel before assuming that the original investment holding period carries through all transaction structures.
Carried interest waiver provisions
In response to Section 1061, many private equity and venture capital fund agreements now include a voluntary carried interest waiver mechanism.
The basic idea is that, at the time of a realization event that would generate gain on an investment held for more than one year but not more than three years, the GP may elect to waive its right to receive the carried interest allocation or corresponding distribution attributable to that gain. In exchange, the GP receives a right to a dollar-for-dollar catch-up from future eligible gains, typically gains from investments held for more than three years.
The one-year point is important. If an investment is sold after one year but before three years, the LPs generally may have long-term capital gain, while the carried interest recipients may have short-term capital gain by reason of Section 1061. In that circumstance, a properly drafted waiver provision can be helpful to the GP without disadvantaging LPs. If the GP waives the carried interest allocation or distribution, LPs may receive more of the current realization proceeds earlier than they otherwise would have received them. That can be favorable to LPs from a timing and IRR perspective. A carried interest waiver also reduces the risk of the GP finding itself in a clawback situation.
By contrast, gains from investments held for one year or less are different. Everyone has short-term capital gain on a sub-one-year sale. A waiver of that gain by the GP should not be used to shift unfavorable tax character to LPs. For that reason, the Section 1061 waiver provisions we typically see are generally focused on the two-to-three-year fact pattern: long-term capital gain for LPs, but short-term capital gain for the carried interest recipients because of Section 1061.
In ideal circumstances, the waiver can put the manager in a similar economic position while avoiding the unfavorable tax result of having carried interest from a three-year-or-fewer gain taxed at ordinary income rates. If the waiver works as intended, the manager gives up the problematic gain and later receives an equivalent amount of carry from better-character gain.
The real-time nature of the election is important.
A fund manager does not make the decision in the abstract at the time the fund is formed. The manager makes the decision prior to an actual exit, with actual facts. That allows the manager to assess the remaining portfolio, the stage of the fund, the likelihood of future gains, the amount of the waived carry, the remaining term, the expected exit pipeline and the risk that the catch-up will never be achieved.
For example, assume investment #1 in a 10-year venture fund exits after two years at a large gain. The fund still has 20 other portfolio companies, a long remaining fund life and significant apparent unrealized upside. In that case, the manager may feel reasonably comfortable waiving the carry attributable to the early exit, because there is a credible possibility that future eligible gains will allow the manager to catch up.
The opposite case is different. If a late-life cycle fund sells one of its last remaining investments before the three-year holding period is satisfied, and there are few remaining assets with meaningful appreciation potential, a waiver may be economically unattractive. The tax benefit may be outweighed by the risk that the manager will never recover the waived carry.
This is why the provision is usually drafted as an option, not a requirement. It gives the GP flexibility to make the decision based on facts existing at the time of the exit.
These waiver provisions should be drafted carefully. The catch-up generally needs to be funded from future appreciation, not from amounts that would otherwise belong to investors without corresponding economic risk to the manager. In addition, carried interest waivers cannot be made after an exit and, in fact, the earlier the waiver is made before a disposition, the more likely the carried interest waiver will survive IRS scrutiny. The provision also typically should be designed so investors are not disadvantaged. From a commercial fairness perspective, managers generally should not be able to waive ordinary income, interest income or gain from investments held for one year or less in a way that shifts unfavorable tax character to taxable investors. The structure also involves tax risk. These waiver structures have not been blessed by Treasury or the IRS and may be subject to challenge or future legislative change.
In practice, however, this architecture has become common enough that many institutional investors are familiar with it. Investors often accept the concept with relatively little pushback if the waiver is voluntary, the manager bears real economic risk of nonrecovery, the catch-up is limited to appropriate future gains, and the provision is not expected to disadvantage LPs. For many LPs, the provision is understandable: The manager is trying to avoid a tax penalty that uniquely affects carried interest, while the LPs are not being asked to give up economics and may receive current proceeds more quickly.
Securities distributions and public stock
Carried interest is not always distributed in cash. Private equity and venture capital funds may distribute public securities or other marketable securities. This is especially common in venture capital after an IPO or public company acquisition, but it also can arise in private equity exits and continuation fund transactions.
Securities distributions create several issues.
First, the fund agreement needs to specify how securities are valued for waterfall purposes. Is value determined by a trailing average, a closing price, a volume-weighted average price (VWAP), the price used for in-kind distribution accounting or another method? What happens if the security is thinly traded, subject to lock-up, subject to volume limitations or not freely transferable?
Second, securities distributions can affect clawback risk. A manager may receive securities at a stated value, but the securities may later decline before they are sold. If the fund later has a clawback, the manager may owe cash, even though the distributed securities have declined in value.
Third, Section 1061 can continue to matter. The final carried interest regulations include rules addressing distributed property and holding periods, and tax counsel should analyze whether the carried interest recipient must continue to hold distributed property to satisfy the three-year requirement.
For these reasons, securities distributions should be coordinated among the waterfall, tax distribution provisions, valuation provisions, clawback provisions, securities law restrictions, insider trading policy and tax advice.
Clawbacks
The final core issue is whether a return obligation, called a clawback, will exist if the GP or carried interest recipients receive more than they are ultimately entitled to retain.
Most private equity and venture capital funds have some form of clawback. The clawback is the backstop that protects investors if carry distributions made earlier in the fund’s life prove, with hindsight, to have been too large.
The basic pattern that creates a clawback is usually the same: early winners, later losers.
Consider again a $100 million fund that ultimately will invest $80 million and spend $20 million on management fees and other expenses. Assume the fund first calls $50 million, uses $10 million for expenses and makes four $10 million investments. The first investment is sold for $90 million. That is an $80 million gain on that investment. Depending on the waterfall, that may be enough to return all $50 million of contributed capital and pay carried interest to the GP. But assume the fund later calls the remaining $50 million, uses $10 million for expenses, invests the remaining $40 million and every other investment goes to zero. The fund has called $100 million in total and distributed only $90 million in total. The fund has not, on a whole-fund basis, returned all contributed capital. If the GP previously received carry on the early winner, it received more than it was ultimately entitled to retain. That is the clawback fact pattern.
In venture capital funds using a European waterfall, the clawback is often assessed once, at liquidation. Interim clawbacks are less common, because the whole-fund waterfall itself substantially reduces overdistribution risk. There is still a statistical possibility of a clawback at liquidation, particularly where the fund has early winners and later losers, but the risk is generally lower than in a deal-by-deal distribution model.
In private equity funds using deal-by-deal carry, clawback mechanics are often more central to the economic bargain. Because the manager may receive carried interest before the entire fund has played out, investors may require more detailed protections. These can include interim clawbacks, escrow of a portion of carry distributions, net worth covenants, guarantees from carry recipients, after-tax clawback limitations, restoration obligations and periodic testing.
One important issue is whether the clawback is before or after tax. Managers generally resist an obligation to return amounts that have already been paid to tax authorities. Investors, for their part, want meaningful protection against overdistribution. Many agreements solve this by providing an after-tax clawback, sometimes with assumptions about tax rates and tax benefits. The drafting can become technical, especially when carry recipients are located in different jurisdictions or subject to different tax rates.
Another issue is credit support. If the clawback arises at liquidation, the fund and GP may have little or no remaining assets. The actual economic source of repayment may be the individual carry recipients. Historically, some agreements used escrows to secure future clawback obligations. Today, escrows are less common in many venture capital funds, though they may appear in certain private equity arrangements. More commonly, the issue is addressed through undertakings or guarantees by the carried interest recipients, sometimes in the fund agreement and sometimes in a separate clawback guaranty.
Managers should pay close attention to how carry is shared internally. A fund agreement may impose a clawback on the GP, but the economic recipients of carry may include partners, employees, former employees, retired partners, estate planning vehicles and other participants. If those recipients have received carry distributions but are not obligated to return their share of any clawback, the GP or remaining principals can be left bearing disproportionate risk. This is an internal governance issue as much as a fund agreement issue.
Practical market observations
For most mainstream private equity and venture capital funds, 20% carry remains the central market reference point. Departures from that baseline are possible, but they should be understood as part of the overall economic package.
In venture capital, premium carry is more common than in many private equity strategies, particularly for managers with very strong realized track records, highly competitive access or brand-driven fundraising leverage. Earned premium carry is more common in current negotiations than flat premium carry for new funds, and it is often easier for LPs to accept because the enhanced economics are tied to enhanced investor returns. Early-stage venture funds often do not include preferred returns and use European waterfalls. Section 1061 waiver provisions are common and particularly relevant for late-stage, opportunity, top-up and SPV investments that may exit inside three years.
In private equity, the headline carry rate also is often 20%, but preferred returns, GP catch-ups, deal-by-deal waterfalls, interim clawbacks, escrows and more detailed clawback security may be more common depending on strategy. Premium carry exists, but investors often evaluate it against the presence or absence of a preferred return, the amount of GP commitment, the manager’s track record, the breadth of the platform and the expected risk-adjusted return profile.
Across both markets, the same basic principle applies. Carried interest is not just a percentage. A 20% carry rate can be economically different depending on whether there is a preferred return, whether expenses reduce the carry base, whether the waterfall is European or American, whether tax distributions are broad or narrow, whether carry can be distributed in securities, whether Section 1061 waiver language is included, and whether the clawback is meaningful.
Conclusion
Carried interest is both an economic term and a behavioral term. It determines how profits are shared, but it also shapes incentives, retention, tax planning, investor alignment and long-term firm culture.
Managers should not treat these provisions as boilerplate. A venture fund with many early investments and long-duration upside may require different carry mechanics than a buyout fund with fewer control investments, leverage and more predictable exit timing. A first-time fund may require different investor protections than a heavily oversubscribed successor fund. A fund that expects late-stage investments, quick exits or continuation transactions should pay particular attention to Section 1061 waiver mechanics.
As is the case with management fees, carried interest is a core compensatory matter in the private equity and venture capital industry. In many cases, it is the most important one. Fund managers will do well to pay attention to market norms – not because every fund needs to look the same, but because investors and managers both benefit from a structure that is understandable, aligned, tax-aware and durable over the life of the fund. Sophisticated investors generally want managers to be strongly motivated to build and harvest value. Managers, for their part, should want carry terms that reward performance without creating avoidable investor friction, tax inefficiency or future disputes.
The authors
