Carried Interest Explained: What It Means and How It Works

Carried interest is one of the most misunderstood compensation terms in finance, but it plays a central role in how private equity firms get paid for profitable investments. This guide to carried interest explains how it works, when it’s paid, and why it’s a key part of aligning the incentives for both private equity managers and investors.

What is Carried Interest?

Carried interest is a performance-based share of a private equity fund’s profits that goes to the fund’s general partners (GPs). This compensation structure is common in leveraged buyouts (LBOs) and other long-term investments where profits are shared.

In most cases, carried interest allows GPs to receive 20% of the profits from successful deals. This 20% is only paid if the fund performs well and meets specific conditions designed to protect investors.

Hurdle Rates

One of those conditions is the hurdle rate, usually set around 8% annually. The fund must exceed this minimum return before any profits are shared with the GP. If it doesn’t, the GP earns no carried interest.

Carried interest isn’t paid out quickly because it depends on long-term results. Most private equity funds run for 7 to 10 years. Usually, it is earned near the end of that period after investments are exited and profits are distributed. 

That delay reinforces what carried interest is really about: rewarding actual performance, not short-term gains.

Real-World Example: 3i’s Investment in Action

To see how carried interest works in practice, consider the example of 3i Group, a major UK-based private equity firm. In 2011, 3i acquired a majority stake in Dutch discount retailer Action for approximately €130 million in a classic LBO deal.

Over the next decade, Action rapidly expanded from 250 stores to over 2,900 stores across 12 countries, becoming one of Europe’s fastest-growing retail chains. By 2024, Action’s enterprise value had climbed to nearly £15 billion. 

This growth generated impressive returns for investors and a significant payout of £735 million in carried interest for 3i’s investment managers. The payouts were made over three installments, reflecting the long-term nature of private equity returns. These distributions were based on the fund’s overall profitability and structured according to the terms of 3i’s investment agreement.

This real-world case illustrates how carried interest is designed to align the GP’s incentives with those of investors and reward long-term performance.

Carried Interest vs. Management Fees

Carried interest and management fees are both ways private equity fund managers get paid, but they serve very different purposes.

Management Fees: The Baseline Compensation

Management fees are the fixed, annual fees that general partners (GPs) charge investors to operate the fund. They’re usually based on a percentage of the fund’s committed capital, typically about 2% per year.

These fees cover day-to-day expenses, such as deal sourcing, due diligence, staff salaries, overhead, and external support like legal expenses.

Management fees are paid regardless of performance. Even if the fund doesn’t meet its hurdle rates, the GPs still collect these fees to keep the fund running.

Management Fees vs. Carried Interest: What’s the Difference?

Why Carried Interest Matters to Investors and Fund Managers

Carried interest is designed to align the interests of private equity managers and investors. When structured well, it motivates GPs to grow the fund’s value responsibly because their compensation depends on long-term performance.

For Investors (LPs): Performance-Driven Accountability

For investors, carried interest is a way to incentivize strong results without increasing upfront costs. GPs only earn a significant payout after investors recover their capital and earn a preferred return.

For Fund Managers (GPs): Skin in the Game

Carried interest ties a fund manager’s reward to the fund’s success. Unlike management fees, which are paid regardless of results, carried interest is only earned when investors achieve strong returns. GPs also contribute their own capital (a “GP commitment”), adding further incentive to perform well.

When the fund succeeds, both investors and managers benefit. If it doesn’t, GPs earn far less.

Next Steps: How Carried Interest Impacts Deal Modeling

Carried interest is easiest to understand when you see how it influences real private equity transactions. Efficiently structured deals that are executed with discipline offer greater potential upside for both investors and GPs earning carried interest. 

That’s why carried interest is more than a line in a compensation agreement. It shapes how deals are structured, how risk is taken, and how returns are modeled before the transaction even closes.

If you want to understand how private equity professionals forecast those outcomes, financial modeling is the next step.

Ready to Level Up Your Deal Modeling Expertise? CFI’s Investment Banking & Private Equity Modeling Specialization equips you with job-ready skills in advanced financial modeling (DCF, LBO, and M&A), valuation, forecasting, and transactional decision making. Learn the techniques used by finance professionals at JPMorgan, BlackRock, KKR, and more!

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