What Is Carried Interest? How AIF Managers Get Paid

Put ₹1 crore or more into a Category I or II AIF and the term sheet shows two numbers: a management fee of perhaps 1.5% or 2% a year, and carry, almost always 20%. The fee gets the attention. The carry is usually the bigger cheque: a 2% fee on ₹100 crore for five years is about ₹10 crore, but if the fund doubles, 20% carry on ₹100 crore of profit is ₹20 crore.

Yet most investors sign without being able to answer three questions. When does the manager start taking carry? Can it take carry on early winners before I get my money back? What happens if it is overpaid? This guide answers them with one rupee example run through the whole distribution waterfall, the SEBI rules as of October 2026, and the tax position.

PMS investors face a cousin of carry, the performance fee charged on a high-water-mark basis, covered in PMS Fees Explained and our guide to the hurdle rate in PMS. This article sticks to pooled, closed-ended AIFs, where carried interest in AIF structures really lives.

Carried interest is the share of a fund's profits that goes to the people who run it, over and above any return on the money they invested themselves. Investopedia describes it as the general partner's profit share, typically about 20% of a fund's returns, and notes that unlike the management fee it is earned only if the fund achieves a pre-agreed minimum return.

In an Indian AIF, usually set up as a trust, investors (LPs in global terms) hold ordinary units. The manager, sponsor or investment team (the GP) hold a separate class, often called carry units, which receive a disproportionate share of profits once investors have been paid what the waterfall promises. Law firm guides describe carry as typically held this way rather than billed as a fee.

Three charges are easy to confuse:

The "2 and 20" label is widely used but is not a fixed market standard in India, and Category I venture funds sometimes charge 20% with no hurdle at all.

Carry can go to the sponsor, the manager or team members. SEBI exempts profit-sharing units issued to the manager's employees from the minimum investment where the employee puts in no money, and team carry often vests over four to five years. For you, one question matters more: is carry held as units with real money behind them, or as a side-letter fee? That drives both your clawback rights and the tax treatment.

The term is commonly traced to 16th-century European trading voyages, when a ship's captain took around 20% of the profit on the goods carried, as a reward for the risk of the crossing.

The 20% figure became the historical standard carry for buyout and venture funds, and its pairing with a 2% management fee gave the industry its shorthand, "2 and 20".

In India the timeline is shorter and more regulatory:

• 2012: SEBI's AIF Regulations required the manager or sponsor to keep a continuing interest in the fund, not met by waiving fees.
• 2014: SEBI circulars required a tabular example of fees and the distribution waterfall in every private placement memorandum (PPM).
• 2021: A Bangalore tax tribunal treated carry in a group of venture funds as consideration for services.
• 2024: The Karnataka High Court set that ruling aside. SEBI gave investors pro-rata rights from 18 November 2024, and a December 2024 circular carved out carry shared with the manager or sponsor.
• 2025: The Finance Act 2025 made securities held by Category I and II funds capital assets from assessment year 2026-27.
• 2026: The Income-tax Act, 2025 took effect on 1 April, and SEBI's consolidated AIF Master Circular followed on 3 June (updated 7 September).

A distribution waterfall is the order in which money from a sold investment is paid out. Think of a row of buckets. Cash fills the first bucket, and only the overflow reaches the next. Most Indian Category II funds use four buckets.

Every rupee you contributed comes back first, including capital used to pay fees and expenses. A fund that called ₹100 crore but invested ₹90 crore must still return ₹100 crore.

Next, investors receive a minimum return, the preferred return or hurdle rate. Industry guides put Indian AIF hurdles at roughly 7% to 12% a year in rupees, with 8% common for Category II equity funds and 10% to 12% for private credit. A hurdle sets the order of payment; it is not a guaranteed return. If the fund earns less, investors keep everything and the manager gets no carry.

A catch-up clause then lets the manager take most or all of the next slice of profit until it has "caught up" to its agreed share. With a 100% catch-up and 20% carry, it takes every rupee in this tier until it holds 20% of all profits paid so far.

Remaining proceeds are then split, most commonly 80:20 between investors and the manager. With a full catch-up and strong returns, the manager ends up with 20% of total profit; the hurdle only changed the timing.

Two funds can both advertise "8% hurdle, 20% carry" and pay their managers very different amounts. The difference sits in the fine print.

"8% per annum" can be simple or compounded. On ₹100 crore held for six years, an 8% simple hurdle produces ₹48 crore of preferred return; compounding produces about ₹58.7 crore. That ₹10.7 crore gap sits with investors before any carry. Check too that the hurdle runs from the date of each drawdown, the investor-friendly version.

A catch-up clause comes in three flavours:

• Full (100%) catch-up: the manager takes all proceeds after the hurdle until it reaches 20% of total profit. Above that point, the hurdle has no effect on the final split.
• Partial catch-up: the slice after the hurdle is shared, say 50:50, so the manager catches up more slowly. Domestic insurance and pension investors sometimes negotiate this.
• No catch-up (a "hard" hurdle): the manager earns 20% only of profits above the hurdle, permanently. This is the most investor-friendly version.

Our worked example below shows that this single clause can halve the manager's carry on the same result.

The second big choice is when the waterfall is run.

In a European waterfall, the manager earns nothing until the portfolio as a whole has repaid you. In an American waterfall, a manager can collect carry on an early winner even if later deals lose money. That is why deal-by-deal funds must carry a strong clawback provision. Commentators note that the European model is the more common one worldwide, while deal-by-deal waterfalls remain popular in venture capital.

Over the fund's life both models should pay roughly the same total if the clawback works. The difference is timing, and the risk that it does not.

Assume a Category II AIF with these terms:

• ₹100 crore contributed by investors (including the manager's own continuing-interest units, which are treated like any other investor's)
• European waterfall, 8% preferred return compounded annually
• 20% carried interest with a 100% catch-up
• All capital invested at the start and all investments sold together at the end of year 5
• Management fees and expenses ignored for clarity (in real life they reduce what flows into the waterfall)

Over five years, 8% compounded on ₹100 crore is ₹46.93 crore. To reach 20% of total profit, the manager's catch-up needs to be one quarter of that figure, ₹11.73 crore. So the catch-up is complete once total proceeds reach about ₹158.7 crore.

How the ₹200 crore exit flows:

1. Return of capital: ₹100 crore to investors.
2. Preferred return: ₹46.93 crore to investors.
3. Catch-up: ₹11.73 crore to the manager.
4. Split: the remaining ₹41.34 crore goes 80:20, so ₹33.07 crore to investors and ₹8.27 crore to the manager.

The manager ends with ₹20 crore, exactly 20% of the ₹100 crore profit. Your gross annual return of 14.87% becomes 12.47% after carry, before fees.

Notice the ₹150 crore row. Investors are held at exactly their 8% preferred return, and every rupee above it goes to the manager's catch-up. In this zone, better fund performance helps the manager, not you.

Remove the catch-up and keep everything else. At a ₹200 crore exit, investors take ₹146.93 crore through the hurdle and the remaining ₹53.07 crore is split 80:20: the manager receives ₹10.61 crore, investors ₹189.39 crore. One clause, and the manager's carry is almost halved. At ₹150 crore, it would get ₹0.61 crore instead of ₹3.07 crore.

To show timing, take a simpler fund: ₹100 crore split equally into Deal A and Deal B, 20% carry, and (to keep the arithmetic clean) no hurdle.

• Deal A is sold in year 2 for ₹100 crore, a ₹50 crore profit.
• Deal B is sold in year 5 for ₹30 crore, a ₹20 crore loss.
• Whole-fund profit is ₹30 crore, so the correct carry is ₹6 crore.

Under an American waterfall, the manager takes 20% of Deal A's profit in year 2, or ₹10 crore. After Deal B's loss it has been overpaid by ₹4 crore, which a clawback provision obliges it to return, usually at the end of the fund. Under a European waterfall, Deal A's ₹100 crore all goes to investors as return of capital, and the manager takes ₹6 crore from Deal B's ₹30 crore. Same final answer, but deal by deal you rely on the manager handing back ₹4 crore three years later.

A clawback provision is a true-up. At the end of the fund (or at interim test dates) the waterfall is re-run on actual results, and any excess carry is repaid. It does not change the carry percentage; it corrects the timing error that early distributions create.

Clawbacks are only as good as the manager's ability to pay, and enforcement against cash already distributed is hard. Hence the add-ons:

• Escrow holdback: part of each carry distribution, which industry guides describe as roughly 20% to 35%, is held back until investors have received their capital or capital plus the preferred return. The figure is negotiated, and there is no single market norm.
• After-tax cap: many agreements limit the clawback to carry received minus tax paid on it, because the manager cannot easily recover tax already paid. Ask whether your fund has one, because it shrinks what you can recover.
• Interim tests: some funds test for overpayment at set dates, not only at wind-up.

The other protection is skin in the game. Under Regulation 10(d) of SEBI's AIF Regulations, the manager or sponsor must keep a continuing interest of at least 2.5% of the corpus or ₹5 crore, whichever is lower, in Category I and II funds, and 5% or ₹10 crore for Category III. It must be real money, not a waived management fee. SEBI also says that when the sponsor or manager invests, its share of losses cannot be less than pro rata to its holding.

SEBI does not set the level of carry, the hurdle or the catch-up; neither the AIF Regulations nor the Master Circular sets a cap. It regulates disclosure, fairness between investors and alignment. The provisions that matter, as of October 2026:

• Waterfall illustration in the PPM: paragraph 2.2.1 of the AIF Master Circular (3 June 2026, updated 7 September 2026) requires a detailed tabular example of fees and charges, including the distribution waterfall. The annual PPM audit checks that waterfall illustrations for different scenarios are accurate.
• Pro-rata rights, with a carry carve-out: Regulation 20(21), in force from 18 November 2024, gives investors rights pro-rata to their commitment in every investment and its proceeds. Paragraph 19.1.3, which consolidates SEBI's 13 December 2024 circular on pro-rata rights, exempts returns shared with the manager or sponsor, "such as carried interest/additional return", under the contribution agreement. For co-investment vehicles and angel funds, the carve-out extends to the manager's employees, directors and partners.
• Continuing interest: the 2.5%/₹5 crore rule above, maintained pro-rata to the money raised from other investors.
• Material change protection: under paragraph 13.1.1, a change in fee structure or hurdle rate that may lead to higher fees is a material change. Existing investors must be offered an exit, with at least one month to dissent.

Together, these rules mean the carry terms you sign are the terms you get; the manager cannot quietly raise them. Whether they are good is for you to judge.

Carried interest taxation has two layers: the fund's income, and the carry holder's receipt. This reflects the law as of October 2026; treatment is partly disputed, so consult a tax adviser before relying on it.

Category I and II AIFs are pass-through vehicles. Under section 224 of the Income-tax Act, 2025 (old section 115UB), income other than business income is taxed in unit holders' hands as if they had invested directly. Carry units are units, so the carry holder's share keeps its character as capital gains, dividends or interest. The fund deducts 10% TDS on income credited to resident unit holders under section 393(1), Table serial 4(iii) (old 194LBB).

The Finance Act 2025 settled one doubt: as the Finance Bill 2025 memorandum explains, from assessment year 2026-27 securities held by Category I and II funds are capital assets, so gains on them are capital gains, not business income. We have not confirmed the clause carrying this into the 2025 Act, so check with your adviser. Category III funds have no statutory pass-through; see our Category 3 AIF taxation guide.

Where carry is paid as distributions on carry units, industry practice treats it as capital gains at the normal rates:

• Listed equity, short-term: 20% under section 196 (old 111A).
• Listed equity, long-term: 12.5% above ₹1.25 lakh under section 198 (old 112A).
• Unlisted shares, long-term: 12.5% under section 197.

A September 2026 CMS guide says the Income-tax Act, 2025 has no specific carried interest regime: carry on carry units defaults to capital gains, but carry treated as a performance fee may be business income taxed at up to 30% plus surcharge and cess. Treelife adds that the Finance Act 2025 change does not codify carry's character in the manager's hands, and that a token or late investment, no real clawback, or side-letter carry weakens the capital gains position. Because pass-through keeps income's character, carry funded by interest in a private credit fund may be taxed as interest.

GST at 18% applies to the management fee; carry is disputed. In 2021 the Bangalore tax tribunal (ICICI Econet) called carry consideration for services, a ruling the industry body IVCA said treated a pooling vehicle as a service provider. In early 2024 the Karnataka High Court set that aside on the principle of mutuality, and legal commentators report that the Supreme Court dismissed the tax department's appeal. That case was under the old service tax law and about the fund, not the manager; our GST on PMS and AIF fees guide covers what remains open.

The United States taxes carry as long-term capital gain only if assets are held for more than three years (section 1061, introduced by the 2017 Tax Cuts and Jobs Act, which raised the period from one year). India has no carry-specific holding rule; ordinary holding periods apply.

Running a waterfall by hand across many drawdowns, partial exits and investors is error-prone, so fund administrators use fund-accounting software that models the tiers, tracks each capital account, runs interim clawback tests and holds escrow balances. Indian rules add three layers:

• Demat: AIF units are issued in dematerialised form, and investments an AIF makes on or after 1 July 2025 must be held in demat.
• Benchmarking: half-yearly reports on data as of 30 September and 31 March compare funds on a common pre-tax NAV basis.
• PPM audits: the annual audit checks whether waterfall illustrations are accurate.

Ask for the waterfall model behind every distribution notice.

Done well, carry is a protection as much as a cost:

• Pay tied to results: the manager earns carry only if the fund clears a pre-agreed return. A fund that returns 7% a year pays no carry in our example.
• Your capital comes first: in a European waterfall you receive all contributed capital and the preferred return before the manager earns anything.
• A minimum return before sharing: the hurdle rate means modest results stay with you.
• Overpayment can be corrected: a clawback provision, backed by escrow, lets investors recover carry paid too early.
• Manager money at risk: SEBI's continuing-interest rule puts at least 2.5% of the corpus or ₹5 crore, whichever is lower, of the manager's or sponsor's own capital into Category I and II funds.
• Terms are disclosed and locked: the PPM must show the waterfall in a worked table, and any fee or hurdle change that raises fees gives you an exit.

Everything above happens inside a fund's PPM and contribution agreement. The decision that comes first is which two or three funds deserve that close reading. That is where PMS Sahi Hai fits, and it is worth being exact about what it does and does not do.

PMS Sahi Hai describes itself as India's first AI-powered PMS and AIF marketplace, tracking PMS, AIF and GIFT City strategies on one shelf.

• Shortlist before you read. The AIF comparison page lists the AIFs the platform tracks, filterable by Category I, II and III, with strategy, vintage, AUM, one-year return, lock-in and a Nyra score. The compare directory lines up to four strategies side by side, and where a fund has not disclosed its fee terms, its fund page shows a blank rather than a guess. That blank is your first question for the manager.
• Ask Nyra the structural questions. Nyra is the platform's AI research analyst. Its page says it is grounded in SEBI, AMC and IFSCA primary sources, cites a source for every answer and declines to answer when no verifiable source exists. Use it to frame the questions in this guide, such as whole-fund versus deal-by-deal, before you meet a manager.
• Read the score for what it is. Nyra rates strategies on five pillars under a published methodology, and shows strategies with under 12 months of track record as "Not Rated". It is built from disclosed performance data; it does not model a fund's waterfall, catch-up or clawback.
• Fill in the basics. Our guides on how AIFs work in India and the AIF pass-through rule cover units, NAV, drawdowns and investor-level tax, which this post only touches.

What the platform does not offer is a carried interest calculator or a fund-by-fund table of hurdle, catch-up and clawback terms. For those, the worked example and question list in this guide, the fund's PPM and your adviser remain the tools. Nyra is an analytical tool, not a SEBI-registered investment adviser.

Carry also has real drawbacks for investors:

• Catch-up dilutes the hurdle: with a full catch-up, the hurdle protects you only in middling years. Once returns are high enough, the manager gets 20% of everything.
• Early carry, late clawback: deal-by-deal funds pay carry early, and clawbacks are hard to enforce once cash is distributed. Escrow percentages are negotiated, with no market norm.
• No regulatory cap: SEBI leaves the carry level, hurdle and catch-up to contract, so terms vary widely between funds.
• Tax uncertainty: carry's character in the manager's hands is not written into law, and GST notices to managers have reportedly continued; depending on the documents, a successful demand could reduce distributions.
• Small drafting choices, large sums: the hurdle basis and the catch-up percentage can each move crores between you and the manager.

At its best, carried interest puts your capital and a minimum return ahead of the manager's profit share. But "20% carry, 8% hurdle" tells you little on its own. Before you commit, ask:

1. Is the waterfall whole-fund (European) or deal-by-deal (American)?
2. Is the hurdle simple or compounded, and does it run from each drawdown date?
3. Is there a catch-up, and is it full or partial?
4. Is there a clawback, when is it tested, and is it capped after tax?
5. What share of carry is held in escrow, and until when?
6. How much has the manager invested under the continuing-interest rule, and when?
7. Is carry paid on carry units with real investment, or under a fee agreement?
8. Can you see the PPM's waterfall table for at least three return scenarios?

Unanswered questions are information too. PMS Sahi Hai's comparison pages and Nyra can narrow the list of funds worth asking.

Two similar-looking AIFs can differ by crores on carry terms alone. Start your shortlist on the PMS Sahi Hai AIF comparison page, put your structural questions to Nyra, and then take each fund's waterfall type, hurdle basis, catch-up, clawback and escrow terms side by side. Ask for the PPM's waterfall table at three return levels, and decide on net outcomes, not headline percentages.