The performance share that turns a general partner’s sweat into hard currency, indexed to profit rather than to assets parked in the fund. Contract language usually earmarks twenty percent of cumulative gains, yet the percentage matters less than the choreography of the distribution waterfall that decides when the share activates. Profits must first restore every dollar of contributed capital and frequently clear a preferred return—an annual hurdle embedded as a guardrail for limited partners. Only then do the gates swing open for catch-up, a sprint in which the general partner accrues the bulk of incremental proceeds until the negotiated split is locked in. Afterward, residual gains flow proportionately between sponsor and investor for the life of the vehicle.
Waterfall geometry varies by jurisdiction and deal type. The American model pays carry deal by deal, granting the sponsor quicker access to upside and relying on clawback provisions to rectify shortfalls later. The European model waits for the fund to cover aggregate loss potential, delaying sponsor reward but reducing clawback exposure. Both frameworks may instruct escrow agents to sequester a slice of distributions until final liquidations confirm compliance with clawback maths, especially when the portfolio contains long-tail assets or valuation subjectivity. Derivative overlays, secondary sales, and recycling clauses further complicate the algebra by reshuffling profit timing.
Accounting captures carry at fair value on the general partner’s statements once performance milestones glide into view, though exact recognition thresholds differ under IFRS and US GAAP. Valuation models discount unrealised gains through scenario-weighted exits, while fee disclosure rules push managers to illuminate every step in the waterfall. Tax treatment remains a lightning rod. In several jurisdictions, including the United States, carried interest currently enjoys capital-gains rates if specific holding-period gates are satisfied. Proposed reforms seek to reclassify portions as ordinary income, prompting sponsors to revisit fund durations, co-investment structures, and deferred-compensation vehicles.
From an investor’s desk, carry turns gross IRR into net IRR, altering capital-allocation equations and influencing re-up decisions. Scenario analysis must integrate the convexity carried interest introduces: moderate wins can feel smaller once the performance slice lifts off, while deep losses leave the sponsor with no performance share, pushing more downside onto the provider of capital. Negotiation therefore gravitates toward alignment tools—higher hurdles, tiered carry rates, and escrow cushions—that balance entrepreneurial incentive against fiduciary caution.
