Carried Interest

Carried interest (or simply carry) is the share of fund profits that flows to the GP / Investment Manager as a performance incentive, over and above the management fee.

The classic '2 and 20':

• 2% annual management fee on committed (or invested) capital
• 20% carry on profits above the preferred return / hurdle rate (commonly 8% IRR)

How it flows — distribution waterfall:

1. Return of capital to LPs — 100% of distributions until LPs receive their drawn-down capital back. 2. Preferred return to LPs — typically 8% IRR on contributed capital. 3. GP catch-up — 100% (or 80/20) to GP until GP has received 20% of profits to date. 4. 80/20 split of remaining profits — 80% to LPs, 20% to GP as carry.

See the Waterfall entry for European vs American waterfall mechanics.

Indian-context: SEBI carry attribution rules (2023–24 onwards):

SEBI now requires AIFs to ensure that carry is paid to key personnel / managers of the AIF in the form of units of the fund, not as a cash fee outside the fund. This 'unitisation' aligns carry with LP economics and was a major change to standard Indian PE / VC documentation.

Tax treatment:

• For Cat I and Cat II AIFs (pass-through), carry historically taxed as business income in the hands of the manager — but recent unitisation rules and Finance Act amendments have nudged the treatment toward capital gains in some structures.
• For Cat III (no pass-through), the tax is borne at fund level and the manager receives a net post-tax distribution.

GIFT City IFSC funds have a separate and generally more favourable carry regime — increasingly attractive for India-focused global LPs.

Pitfall: Many first-time GPs do not appreciate that clawback mechanics can require them to return carry already received if late-stage losses erode LP returns. Model clawback exposure quarterly.