Preferred Return and Carried Interest Explained
A preferred return is a minimum annual return investors receive before the sponsor shares in profits. Carried interest, or the promote, is the sponsor's share of profits above that hurdle. A typical waterfall first returns capital, then pays the preferred return, then may give the sponsor a catch-up, and then splits remaining profits between investors and sponsor in an agreed ratio. The exact terms are negotiated and set out in the governing agreement.
The usual order of payments
- Return of capital. Investors receive their contributions back.
- Preferred return. Investors receive a stated annual return on their capital, often compounding.
- Catch-up (optional). The sponsor receives a larger share until it has caught up to its agreed percentage of total profits.
- Carried interest split. Remaining profit is divided between investors and sponsor, such as 80 to investors and 20 to sponsor.
Some waterfalls have several tiers with higher sponsor percentages as returns rise.
A simple illustration
This is an example only, not a recommendation. Assume investors contribute $1,000,000, the preferred return is 8 percent and the carry is 20 percent with no catch-up. If the fund returns $1,500,000, investors first receive their $1,000,000. They then receive the accrued preferred return. The remaining profit is split 80 to investors and 20 to the sponsor. With a catch-up, the sponsor would receive a larger share of profit after the preferred return until it holds 20 percent of total profit, and then the 80 and 20 split applies.
Deal-by-deal vs whole-fund
| Deal by deal | Whole fund | |
|---|---|---|
| When the sponsor gets carry | After each investment is sold, even if others lose money | After investors get capital and preferred return across the whole fund |
| Investor view | Riskier for investors | More investor-friendly |
| Protection | Clawback provisions are common | Less need for clawback |
Clawbacks and escrows
A clawback requires the sponsor to return excess carry if, over the life of the fund, it was paid more than its share. Some funds hold back part of carried interest in escrow. These protections matter in deal-by-deal waterfalls, since early gains can be followed by later losses.
Taxes and presentation
Carried interest is generally taxed as capital gain if the underlying gain qualifies, subject to a three-year holding period rule for certain gains. Tax rules in this area change, so have a tax advisor review the structure. The PPM should describe the waterfall in plain terms, with an example. See what a PPM contains and GP and LP structure.
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Book Free ConsultationFrequently asked questions
Is a preferred return guaranteed?
No. It is a priority in the order of payments, not a promise that the fund will generate it.
What is a catch-up?
A tier that gives the sponsor extra profit after the preferred return until it holds its target share of total profits.
Does carried interest mean the sponsor is paid first?
No. Investors are paid back and receive the preferred return before the sponsor receives carry.
Is promote the same as carried interest?
The terms are used interchangeably, though promote is more common in real estate and carry in private equity.