In the world of alternative investments, hedge fund carried interest is one of the most powerful and controversial concepts. For fund managers, it is the primary engine of wealth creation; for investors, it is a critical alignment tool that ensures their manager’s "skin in the game."
Whether you are a seasoned Limited Partner (LP) or a curious newcomer to high-finance, understanding the mechanics of carried interest is essential for evaluating fund performance and costs.
What is Carried Interest?
Carried interest, often referred simply as "carry," is the share of a fund's net profits that is paid to the General Partner (GP) or fund manager as performance-based compensation. Unlike a standard salary, carry is only earned if the fund generates positive returns for its investors.
In the classic "2 and 20" fee structure, the hedge fund carried interest represents the "20" portion:
- 2% Management Fee: A flat fee based on Assets Under Management (AUM) to cover operating costs (salaries, rent, technology).
- 20% Carried Interest: A performance fee that entitles the manager to 20% of the profits generated beyond a specific threshold.
How It Works: The Investor’s Perspective
Carry is designed to align the manager's incentives with those of the investors. If the fund loses money, the manager receives zero carried interest. To protect investors further, most funds utilize two key mechanisms:
- The Hurdle Rate
A "hurdle" is the minimum return a fund must achieve before the manager can start collecting carry. For example, if a fund has an 8% hurdle rate and only returns 7%, the manager receives no carry.
- The High-Water Mark
This is perhaps the most vital protection for hedge fund investors. A high-water mark prevents a manager from collecting a performance fee on the same gains twice. If a fund loses 10% in Year 1 and gains 10% in Year 2, the manager cannot collect carry for Year 2 because the fund has not yet surpassed its previous peak value.
Carried Interest vs. Performance Fees
While the terms are often used interchangeably in casual conversation, there is a technical distinction.
- Carried Interest is typically structured as an allocation of a partnership’s profits. In private equity, this is usually paid upon the "exit" or sale of an asset.
- Performance Fees in hedge funds are often calculated and crystallized annually because hedge funds deal with more liquid assets (stocks, bonds, currencies) that can be valued frequently.
The 2026 Tax Landscape
The taxation of hedge fund carried interest has long been a subject of political debate. Historically, carry has been taxed at long-term capital gains rates (roughly 20% in the U.S.) rather than ordinary income rates (up to 37%), provided certain holding periods are met.
As of 2026, many jurisdictions have tightened these rules:
- The Three-Year Rule: In the U.S., managers must generally hold assets for at least three years to qualify for the preferential capital gains rate.
- Global Reform: In regions like the UK, new 2026 regulations treat "non-qualifying" carry as trading profits, potentially subjecting them to higher income tax rates.
Summary for Investors
For an investor, carried interest is a double-edged sword. While it reduces your net return, it is also the reason the world's most talented managers are willing to work 80-hour weeks to find "alpha" (excess returns). When evaluating a fund, always look past the 20% figure and scrutinize the hurdle rates and clawback provisions to ensure the carry is truly earned.
