By Gregory M. Prekupec & Rahul Gupta

In the world of private equity (PE) and venture capital (VC), few concepts spark as much curiosity—and confusion—as carried interest. Commonly referred to as “carry,” this structure sits at the heart of how fund managers get paid for their performance. But carried interest is more than just a compensation mechanism; it’s a powerful tool for aligning the interests of general partners (GPs) and investors, and one that raises interesting legal, structural, and tax considerations.

At its core, carried interest represents a share of a fund’s profits allocated to the GP—typically 20%—even though the GP may have contributed very little capital. This performance fee is designed to incentivize managers to maximize the fund’s return. But unlike a flat management fee, carried interest is only paid if the fund achieves profitable outcomes. In other words, it’s a bet that fund managers are willing to make on themselves.

Legal Structure

In Canada, private equity and venture capital funds are most commonly structured as limited partnerships (LPs). The investors come in as limited partners, while the general partner manages the fund’s day-to-day operations and investment strategy.

The LP Agreement governs the operations, capital contributions, and distributions of profits—including the carried interest. Importantly, the GP may be incentivized through carry to maximize profits for all, but the legal documents must be airtight in specifying how those profits are calculated, when distributions are made, and who ultimately gets paid. These provisions are especially important in determining how the infamous “waterfall” of payments will cascade down once an investment is exited.

Lawyers advising on fund formation must pay close attention to how carry is distributed, vested, and potentially clawed back.

The Mechanics

Carry is usually paid only after limited partners have recovered their invested capital and, often, a preferred return (known as a hurdle rate). After these benchmarks are met, excess profits are split—typically 80% to investors and 20% to the GP.

These allocations can vary. Some funds adopt a “whole-fund” carry model, where returns must be measured against the fund’s total performance, while others opt for a “deal-by-deal” structure, which rewards success on individual investments. Vesting schedules also vary, commonly spanning 3–6 years to ensure long-term alignment between fund managers and investors.

From a legal standpoint, carry provisions must balance flexibility and fairness—ensuring that carry rights aren’t abused but also rewarding the GP appropriately for generating returns.

Risk Management

Claw back provisions are a critical piece of carried interest mechanics. They protect investors in scenarios where early carry distributions to the GP prove excessive due to later losses. If fund performance drops, clawback clauses may require the GP to return a portion of prior profits. However, enforcing clawbacks—especially from GPs or team members who’ve left—can be difficult.

Escrow accounts are a common solution, holding a portion of carry until final fund liquidation. This gives the fund some security in reclaiming overpaid amounts. As legal counsel, I emphasize precise language in LP Agreements to reduce ambiguity in claw back enforcement.

It’s a delicate balance: we must incentivize high performance without letting early wins skew the long-term economic reality.

Tax and Emerging Trends

In Canada, carried interest is generally taxed as business income. Unlike capital gains, this means higher tax rates for the recipients. There’s also the “phantom income” issue, where GPs may owe taxes on carry allocations they haven’t yet received in cash. Many funds address this with periodic distributions to cover tax liabilities.

There’s growing discussion around whether carried interest should be taxed as capital gains to better reflect its investment-like nature. As lawyers, we must remain agile in advising on evolving tax interpretations and structuring compensation accordingly.

With more funds forming and more capital flowing into Canadian private markets, understanding carried interest isn’t just about economics—it’s about good governance, proper incentive alignment, and legal precision. As legal advisors, we stand at the intersection of strategy and structure, helping to design frameworks that drive both compliance and performance.