In private equity, the promote is the general partner’s share of a fund’s profits, usually 20% of net gains, paid only after the limited partners have received back their invested capital plus a minimum return called the preferred return. It is the same thing lawyers and tax professionals call carried interest, and it is the main reason managing a fund can be lucrative. Everything else about the promote in private equity, including when it gets paid, how it is taxed, and what can claw it back, flows from that basic definition.
How the GP Actually Gets Paid
A private equity fund is a limited partnership. The general partner runs the investments. The limited partners, usually pension funds, endowments, and insurance companies, put up the vast majority of the money. The GP earns from two separate streams.
The first is the management fee. It is a recurring annual charge, usually 1.5% to 2% of committed capital during the investment period, and it gets paid whether or not the fund makes money. It covers salaries, offices, and deal sourcing.
The second is carried interest, the promote itself. The GP collects nothing from carry unless the fund clears a contractual hurdle, typically a 7% to 8% annual internal rate of return to the LPs. Above that, the GP takes its cut of the profits. The industry shorthand “2 and 20” captures the combination: a 2% management fee plus a 20% profit share.
The GP also has its own money in the fund. GPs typically commit 1% to 5% of total fund capital themselves. That capital travels through the same distribution sequence as the LPs’ capital, and it often doubles as collateral if the GP later owes money back under a clawback.
All of these terms live in the Limited Partnership Agreement, which spells out the hurdle rate, the carry percentage, and the exact order in which cash moves from the fund to the investors and the GP.
The Distribution Waterfall
The waterfall is the rigid sequence that routes every dollar of realized profit. Most U.S. private equity funds use a four-tier American-style waterfall, which runs the calculation deal by deal.
Tier 1: Return of Capital
Every dollar of profit goes to the LPs until they have gotten back their entire original investment. The GP earns nothing from the promote during this phase.
Tier 2: Preferred Return
Profits keep flowing entirely to the LPs until they have earned the preferred return, typically a cumulative 7% to 8% IRR on their invested capital. This compensates investors for the time their money is locked up.
Tier 3: GP Catch-Up
Now the flow reverses heavily toward the GP. Under a standard 20% carry with a full catch-up, 100% of the next slice of profits goes to the GP until its total take equals 20% of all profits paid out in Tiers 2 and 3 combined. Some funds negotiate a partial catch-up, such as 50/50 or 80/20, which slows the GP’s path to parity.
Tier 4: The Ongoing 80/20 Split
Everything after the catch-up splits 80/20 between the LPs and the GP for the rest of the fund’s life. This is the steady-state share that keeps running as long as the fund keeps generating gains.
American vs. European Waterfalls
The split above describes an American-style, deal-by-deal waterfall. If the fund’s first investment doubles, the GP can start collecting carry on that deal before the other investments are realized. The risk is obvious: early winners might fund GP carry that later losers would have erased.
A European-style waterfall, sometimes called a whole-fund waterfall, closes that gap. The GP earns no carry at all until every dollar of LP capital across the entire fund has been returned and the preferred return on the whole portfolio has been met. LPs prefer this structure because it eliminates the possibility of paying carry on paper gains that never pan out. Most U.S. buyout and growth equity funds still use the American version and address the early-winner problem with clawbacks instead.
Clawbacks: Getting Carry Back
A clawback requires the GP to return excess carry if, when the fund winds down, the GP’s total distributions exceed the agreed share of total profits. The calculation happens once, at the end, on a cumulative basis across every deal the fund ever did. A fund that paid out generous carry on its first five deals and then lost money on the next five can trigger a substantial clawback even if the GP acted reasonably on each individual investment.
Collecting on a clawback years after the money was spent is the hard part. LPAs use a few mechanisms to make the obligation real:
- Escrow accounts that hold back a portion of each carry distribution until the final calculation. The Institutional Limited Partners Association recommends at least 30% of carry be escrowed.
- Personal guarantees from individual GP members, often backed by the GP’s own capital commitment to the fund. The strongest version is joint and several liability, meaning any one GP member can be pursued for the full amount; GPs push for several liability, limiting each person to their pro rata share.
- LP enforcement rights that let investors go directly after individual GP members rather than relying on the GP entity to sue its own executives.
How Carried Interest Is Taxed
Because the promote is structured as a share of partnership profits rather than payment for services, it can qualify for long-term capital gains rates instead of ordinary income rates. That difference can cut the GP’s tax bill nearly in half, which is why the taxation of carry is one of the most argued-over subjects in fund economics.
The Three-Year Holding Period
Internal Revenue Code Section 1061, added by the Tax Cuts and Jobs Act of 2017, created a special rule for what the statute calls an “applicable partnership interest.” The ordinary one-year holding period for long-term capital gains is raised to more than three years for carried interest. If the fund sells an asset within three years, the GP’s share of the gain is recharacterized as short-term and taxed at ordinary income rates, which top out at 37% federally. The partnership reports the Section 1061 information to the GP on Schedule K-1 (Form 1065) using Code AM in Box 20.
Long-Term Rates, Plus the NIIT
When the three-year threshold is met, the carry qualifies for long-term capital gains treatment, with a top federal rate of 20%. High earners also owe the 3.8% Net Investment Income Tax, which applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly. Those thresholds are not indexed for inflation. The combined maximum federal rate on qualifying carry is 23.8%.
State Taxes
Most states tax capital gains as ordinary income. Top state rates run from zero in no-income-tax states to over 13% in the highest. A GP in a high-tax state can face a combined federal and state burden above 37% even on long-term gains, though state sourcing rules complicate any move intended to escape it.
Estate Planning With a Promote
A promote in a fund that has not yet realized its gains can carry a low current fair market value, which makes it attractive to transfer early to family members or trusts. Future appreciation then grows outside the GP’s taxable estate.
The trap is IRC Section 2701, which governs transfers of partnership interests where senior and junior interests have different economic rights. A GP who holds both a capital interest and a carried interest and transfers only the carry can trigger valuation rules that treat the transferred interest as worth zero for gift tax purposes, which perversely inflates the deemed gift. The standard workaround is the “vertical slice” exception under Treasury Regulation Section 25.2701-1(c)(4): transfer a proportionate share of every class of equity, often by rolling all of the GP’s fund interests into an LLC and gifting membership units. Because each unit represents the same proportional slice of capital and carry, Section 2701’s special valuation rules do not apply.
Valuing a promote before gains are realized is its own exercise. Appraisers use discounted cash flow models or Monte Carlo simulations, and the IRS scrutinizes the discount rate and any marketability discount, so a defensible appraisal from the start is worth the cost.