Hurdle Rate

How a hurdle rate works

In a fund, the hurdle rate is the return investors must receive before the manager shares in profits. The Institutional Limited Partners Association defines it as the minimum return to investors to be achieved before a carry is permitted, and illustrates it directly: a hurdle rate of 10 percent means the fund needs to achieve a return of at least 10 percent per annum. The same threshold is called the preferred return, and in sponsor-led real asset deals simply the pref.

The hurdle is an accrual, not a payment. It builds up on capital that investors have actually put in, from the moment they put it in, and it is satisfied out of distributions when distributions occur.

Preferred return accrued = contributed capital x ((1 + r)^t - 1), compounded and tracked separately for each contribution

Hurdle cleared when cumulative distributions are greater than or equal to contributed capital plus accrued preferred return

ILPA's Principles are specific about the start date. The preferred return should be calculated from the date capital is called from limited partners to the point of distribution. Where capital is drawn from a bridging or other short-term facility collateralized by uncalled commitments, it should be calculated from the date capital is at risk, meaning the date the facility is drawn, rather than the date capital is finally called. The Principles also say the calculation should run on the partnership's cumulative investment history, from the point an investor's capital is put at risk through the full distribution of the preferred return on the last exited investment, and that whatever accrual method is used should be fully transparent and consistent over the life of the fund.

Two structures then determine what the hurdle actually costs the manager.

A hard hurdle means carried interest is charged only on profits above the threshold. The preferred return stays with investors permanently. ILPA's Principles recommend this form, saying the carry calculation should ideally use a hard hurdle whereby the general partner's carried interest is based only on the portion of profits that exceed the limited partners' preferred return, and that a manager may consider using one to foster greater alignment.

A soft hurdle means the threshold is a timing gate rather than a permanent allocation. Once investors have received the preferred return, a catch-up tier pays the manager all or most of the next distributions until it holds its full carry percentage of total profits, including the profits that made up the preferred return.

Catch-up = carry rate x preferred return paid / (1 - carry rate)

The variables worth checking in any specific fund are the rate, whether it compounds and how often, whether it accrues on contributed capital only or also on capital contributed to pay fees and expenses, whether it is expressed as an annual rate or as a multiple of capital, and whether the catch-up is at 100 percent or a slower rate such as 80 percent to the manager.

The phrase also has a second, unrelated meaning in corporate finance, where a hurdle rate is the minimum acceptable rate of return a company requires before approving a capital project, typically set at or above the weighted average cost of capital plus a risk premium, and used as the discount rate against which a project's internal rate of return is tested. The two usages share only the word.

Worked example

Suppose a fund has drawn 100 million dollars from limited partners and ultimately distributes 200 million dollars. The preferred return accrued across the fund's life, given the timing of each call, works out to 35 million dollars. The carry rate is 20 percent. All figures are hypothetical.

Case one: soft hurdle with a 100 percent catch-up.

Step one: return of capital. The first 100 million goes to limited partners.

Step two: preferred return. The next 35 million goes to limited partners, satisfying the hurdle. Total profit distributed so far is 35 million, all of it to investors.

Step three: catch-up. The manager now receives distributions until it holds 20 percent of profits distributed. Applying the formula, 0.20 x 35 / 0.80 = 8.75 million dollars. At that point total profit distributed is 43.75 million, of which the manager holds 8.75 million, which is exactly 20 percent.

Step four: residual. Remaining distributions are 200 minus 100 minus 35 minus 8.75, or 56.25 million, split 80 percent to limited partners and 20 percent to the manager: 45 million and 11.25 million.

Step five: totals. The manager receives 8.75 plus 11.25, or 20 million dollars, which is 20 percent of the fund's full 100 million dollar profit. Limited partners receive 180 million. The hurdle delayed the manager's carry but did not reduce it.

Case two: hard hurdle, same numbers.

Step one and two are identical: 100 million of capital and 35 million of preferred return go to limited partners.

Step three: there is no catch-up. The manager takes 20 percent only of profits above the preferred return: 0.20 x (100 - 35) = 13 million dollars.

Step four: totals. Limited partners receive 187 million, the manager 13 million.

The difference between the two structures, on identical performance, is 7 million dollars. The headline carry rate is 20 percent in both cases. This is why the structure is negotiated as hard as the rate.

Where it shows up

In the limited partnership agreement, the hurdle appears as the defined term Preferred Return and again inside the distributions article, which lists the tiers in order: return of capital contributions, then the preferred return, then a general partner catch-up if there is one, then the residual split. ILPA asks that these provisions be drafted so a non-legal professional can follow them, and that investors be given a model of how fees, expenses and carried interest will be calculated over the fund's life.

In the private placement memorandum's summary of terms, it is one line, typically stated as a percentage with the words compounded annually, alongside the carry rate, the catch-up and the waterfall type. Those four items together, not the carry rate alone, describe the manager's economics.

In the distribution notice sent with each payment, the allocation across waterfall tiers is shown, so a limited partner can see how much of a distribution was return of capital, how much satisfied the preferred return, and how much was carry. ILPA publishes best practice formats for capital call and distribution notices covering that presentation.

In the capital account statement and quarterly report, the accrued but unpaid preferred return and the accrued carried interest both appear, showing where the fund sits relative to the threshold as of the reporting date.

Common mistakes

• Treating the hurdle as a guarantee. It is a distribution priority, not a promise. If the fund does not earn it, nobody pays it.
• Confusing hard and soft. With a catch-up, the manager ends up with its full percentage of all profits. Without one, investors keep the hurdle permanently. Same rate, different money.
• Ignoring the accrual start date. Accruing from the date of the capital call rather than the date capital was actually at risk behind a subscription line understates what investors are owed, which is why ILPA addresses it explicitly.
• Overlooking compounding frequency. Annual, quarterly and simple accrual produce materially different balances over an eight-year hold.
• Assuming every fund has one. Preferred returns are conventional in buyout and real asset funds and frequently absent in venture funds. The only reliable answer is in the specific partnership agreement.
• Confusing the fund usage with the corporate finance usage. A capital budgeting hurdle rate is a required return on a project, not a distribution tier.
• Reading the rate without the waterfall shape. A whole-of-fund waterfall with an 8 percent hurdle and a deal-by-deal waterfall with an 8 percent hurdle pay the manager on very different schedules.

Related terms

The hurdle rate is the gate in front of carried interest, and it sits inside the distribution waterfall between return of capital and the residual split. Because it is usually expressed as an annualized return, it is computed like an IRR on contributed capital. Where a manager is paid early against a hurdle that later performance does not support, the clawback is what returns the money, and the balance of these terms is the core negotiation between the general partner and its limited partners.

Frequently asked questions

What is the hurdle rate formula?

For a fund, the accrued preferred return on a contribution is the contributed amount multiplied by ((1 + r) raised to the power of the time elapsed, minus 1), tracked from the date of each call and compounded at the frequency the agreement specifies. The hurdle is cleared once cumulative distributions equal contributed capital plus that accrued amount. In corporate finance, a hurdle rate is set rather than derived, usually as the weighted average cost of capital plus a risk premium.

What is a typical hurdle rate in private equity?

An 8 percent compounded annual preferred return is the figure most often quoted in buyout and real asset funds, though that is market convention rather than a documented standard, and ILPA's own glossary uses 10 percent as its worked illustration. Venture funds frequently have no hurdle at all: ILPA's glossary says the mechanism is commonly found in buyout and development capital funds but rarely in venture funds. The rate alone is not enough information: the accrual start date, the compounding frequency, and whether the hurdle is hard or soft all change what it is worth.

What is the difference between a hard hurdle and a soft hurdle?

With a hard hurdle, the manager earns carry only on profits above the threshold, so investors keep the preferred return permanently. With a soft hurdle, a catch-up tier lets the manager recover carry on those profits too, so the threshold affects timing rather than the final split. ILPA's Principles recommend the hard hurdle for alignment.

What is a catch-up and how is it calculated?

A catch-up is the waterfall tier that pays the manager after the preferred return has been satisfied, until the manager holds its full carry percentage of all profits distributed. At a 100 percent catch-up rate and a 20 percent carry, the catch-up amount equals 0.20 times the preferred return paid, divided by 0.80. A slower catch-up rate, such as 80 percent to the manager and 20 percent to investors, stretches the same amount over more distributions.

Does the hurdle rate apply to committed or contributed capital?

Contributed capital, as a rule, accruing from the date each contribution is made. ILPA's Principles say the preferred return should be calculated from the date capital is called from limited partners to the point of distribution, and from the date capital is at risk where a subscription facility is used. Uncalled commitments do not accrue a preferred return.

Why do venture funds often have no hurdle rate?

Because venture returns are expected to come from a small number of very large outcomes rather than from steady compounding, a threshold calibrated to a fixed annual rate does relatively little work: a fund that clears it usually clears it by a wide margin, and a fund that does not clear it usually is not close. Conventions differ by strategy and by manager, and the fund's own agreement is the only authority.

Related tools and reading

• Carry Calculator
• Waterfall Calculator
• Seed Funding Guide
• LP Reporting Software