Carried Interest Explained: 2 and 20, the Hurdle, Catch-Up and Clawback

If private equity is your next step after investment banking, you should be able to explain carried interest in thirty seconds. Most candidates can recite "2 and 20". Fewer can explain the order the money moves in, and the follow-up questions all sit there.

The 2 and 20 behind carried interest

A private equity firm raises money from outside investors called limited partners (LPs), such as pension funds and endowments. The firm acts as the general partner (GP), picks the deals and decides when to sell. It earns two things.

• The management fee, the "2". An annual fee, commonly cited at about 2%, that the GP charges whatever the fund's performance. It covers the firm's salaries and overheads.
• Carried interest, the "20". A share of the fund's profits, commonly cited at 20%, that the GP earns only after investors have received a minimum return.

Investopedia's entry on carried interest gives the same figures: carry of typically 20% of a fund's returns, with many GPs also charging a 2% annual fee. The real terms sit in each fund's limited partnership agreement (LPA), negotiated fund by fund.

Carry is 20% of the profits. Say "the GP keeps a fifth of the fund" and you have told the interviewer you have never looked at a waterfall.

The distribution waterfall, tier by tier

Each time the fund returns cash, the money flows through a fixed sequence of tiers called the distribution waterfall.

1. Return of capital. LPs get back the money they contributed.
2. Preferred return, or hurdle. LPs receive a minimum annual return on that capital before the GP takes any carry. The LPA sets the rate.
3. GP catch-up. The GP then takes all or most of the next distributions until it has received its full carry percentage of the profit paid out so far.
4. The split. Everything after that divides at the carry rate: 80/20 for a 20% carry.

An illustrative carried interest waterfall

LPs invest $200m and the fund returns $360m, a profit of $160m. Terms are 20% carry, an 8% preferred return and a 100% catch-up. Assume the pref owed when the cash comes back is $40m (about two and a half years at 8% on $200m, before compounding).

Illustrative round numbers, not drawn from any real fund.

Only the catch-up needs working out. The GP takes everything until it holds 20% of the profit paid out so far, which is the $40m pref plus its own take. So it needs $10m, or 20% of $50m, and the remaining $110m splits 80/20.

The GP collects $32m, which is 20% of the $160m profit, and the LPs keep the other $128m. Run that check on any waterfall you build.

Two variations show what each tier does. Remove the catch-up and the GP receives 20% of the $120m left after the pref, or $24m. Cut the fund's total return to $230m and LPs take all of it ($200m of capital and $30m of a $40m pref), while the GP earns no carry.

European vs American waterfalls

The tiers can run across the whole fund or deal by deal, which changes when the GP gets paid.

• European, or whole-fund. LPs get back all their contributed capital across the fund, plus the pref, before the GP takes any carry.
• American, or deal-by-deal. The waterfall runs on each deal as it exits, so a strong early sale can pay the GP carry years before the weaker deals finish.

A second illustration, with the hurdle set aside. The fund puts $100m into each of two companies. Deal A sells early for $200m; Deal B sells later for $40m. Deal by deal, the GP takes 20% of Deal A's $100m profit the day it sells. Whole-fund, Deal A's $200m goes to LPs as returned capital and the GP waits until Deal B sells, which leaves a profit of $40m across the fund.

Clawback: fixing an overpaid GP

In the deal-by-deal version, the GP holds $12m more than the whole fund justifies. The clawback is the LPA clause that makes the GP return that excess, tested on the fund's cumulative results. An LPA can secure it by holding part of each carry payment in escrow. In an interview, link the two: deal-by-deal pays the GP earlier, and the clawback protects LPs from the result.

Why carry matters if you want banking, then private equity

Carry changes how you read a private equity offer. It arrives, if you get any, when deals exit, and the same Investopedia entry notes it typically vests over a number of years. Ask whether your role participates and what happens to unvested carry if you leave. The hurdle also grows with time, so a slow exit can miss it even at a decent multiple. Expect PE interviewers to press you on IRR as well as the multiple of money.

If a sponsor hires your bank to sell a portfolio company, the price you achieve helps decide whether the fund clears its hurdle. See how the M&A sell-side process runs and how valuation multiples frame that exit price.

Carry also makes headlines for its tax treatment. Under the IRS's section 1061 rules, gains allocated through a carried interest (the rules call it an "applicable partnership interest") generally count as long-term only if the asset was held for more than three years. Critics call that a loophole; supporters say it rewards long-term risk. Describe both sides and move on.

The 30-second answer

"A private equity firm earns a management fee, commonly around 2% a year, and carried interest, commonly around 20% of profits. Cash flows through a waterfall: capital back to investors, then a preferred return, then a GP catch-up, then an 80/20 split. A whole-fund waterfall makes the GP wait until investors are whole across the fund. Deal-by-deal pays on each exit, with a clawback if the GP ends up overpaid."

Then stop. If they ask which waterfall you would rather be paid under, give both sides: the GP prefers American, because cash today beats cash later, and the LP prefers European.

How to make it stick this week

1. Rebuild the waterfall from a blank page with your own numbers and check the GP lands on 20% of total profit. If it does not, your catch-up is wrong.
2. Run the two-deal fund both ways and calculate the clawback without looking.
3. Say the 30-second answer out loud against a timer. Reading an answer and producing one are separate skills, as Knowing the Answer Is Not the Same as Passing explains.

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