The hurdle rate is the minimum rate of return a fund must achieve on LP capital before the general partner becomes entitled to carried interest. It is the threshold that separates LP-only profit participation (below the hurdle) from shared profit participation between LPs and the GP (above the hurdle).
How it works
The hurdle rate and the preferred return are closely related but technically distinct concepts. The hurdle rate is the threshold: the rate of return a fund must clear. The preferred return is the accumulated amount that LPs must receive before carry becomes payable. In practice, most fund documents use both terms interchangeably or use one to define the other.
The most common institutional PE hurdle rate is 8% per annum. In a European waterfall, this means LPs must receive their contributed capital back plus 8% compounded per annum before the GP catch-up tier begins. In an American (deal-by-deal) waterfall, the hurdle is tested on each investment realisation independently. The structural difference has significant economic implications: a deal-by-deal hurdle can result in GP carry on a winning investment even when the overall fund is below the hurdle.
Some funds use a non-compounding (simple interest) hurdle, which produces lower preferred return accruals than a compounding hurdle over long holding periods. Others use a net-of-fee hurdle, meaning the preferred return accrues on capital after management fees, reducing the effective threshold. The calculation basis is specified in the LPA and material to LP economics.
Private credit funds frequently use higher hurdle rates than PE funds (often 8-12%), because their target gross returns are lower and their risk profile is different. A credit fund targeting 12-14% gross returns would be expected to use a hurdle of 10-12% to ensure meaningful carry for the GP while preserving meaningful economics for LPs. Some credit funds use a zero-hurdle structure where carry applies from the first dollar of profit, typically at a lower carry rate (5-10%).
Worked example
Clearwater Private Equity Fund II uses an 8% per annum hurdle rate, compounded, with a European (whole-fund) waterfall. The fund has GBP 300M in total contributions. After five years, a realisation produces GBP 450M in proceeds.
Total preferred return accrued (8% compounded on GBP 300M over five years): GBP 300M x [(1.08)^5 - 1] = approximately GBP 140.8M.
Waterfall calculation: Tier 1 (return of capital) = GBP 300M to LPs. Remaining: GBP 150M. Tier 2 (preferred return to hurdle) = GBP 140.8M to LPs. Remaining: GBP 9.2M. Tier 3 (GP catch-up): GP target is 20% of total profit (GBP 140.8M + GBP 9.2M = GBP 150M profit); GP target = GBP 30M, but only GBP 9.2M remains, so GP receives all GBP 9.2M in catch-up (GP is still behind its target catch-up position; the fund has insufficient proceeds to complete the catch-up). Total GP carry: GBP 9.2M; total LP distributions: GBP 440.8M.
If proceeds were GBP 600M instead: the catch-up (GBP 30M target) could be fully paid from the GBP 159.2M remaining after Tiers 1 and 2; residual of GBP 129.2M splits 80:20, adding GBP 25.84M GP carry. Total GP carry: GBP 55.84M.
Frequently asked questions
What is the difference between hurdle rate and preferred return? Technically, the hurdle rate is the threshold rate (e.g. 8% per annum) and the preferred return is the accumulated amount payable to LPs to satisfy that hurdle. In practice, most fund documents use the terms synonymously. The distinction matters when the LPA specifies the mechanics: whether the preferred return is compounded or simple interest, and whether it accrues on all contributed capital or only on invested capital.
Do all private funds have a hurdle rate? No. Some VC funds and a smaller number of PE funds operate without a preferred return or hurdle, meaning the GP earns carry from the first dollar of profit. This structure is more common in top-quartile managers with strong negotiating positions and in growth equity funds. LPs who accept no-hurdle terms typically negotiate other protections, such as lower carry rates or clawback provisions with shorter settlement windows.
How does a high hurdle rate affect GP fundraising? A higher hurdle rate is LP-friendly because it increases the proportion of profits that LPs receive before any carry flows to the GP. GPs with strong performance records can command lower hurdle rates (or no hurdle) because LPs are willing to compromise on terms to access the fund. First-time managers typically face pressure to accept higher hurdle rates or other LP-protective terms.
Can the hurdle rate change mid-fund? The hurdle rate is fixed in the LPA at fund formation and cannot be changed unilaterally. Modification would require LP consent, typically a supermajority of LP interests. In practice, hurdle rate modifications during a fund's life are extremely rare.
Related terms
Preferred return, Carried interest, GP catch-up, Distribution waterfall, Clawback, Capital account
Related pages
Waterfall mechanics in private fund administration, Swelv for fund administrators