What Is a Hurdle Rate?
A hurdle rate is the return threshold that protects investors in a private fund: the general partner earns no share of profits until limited partners have received their capital back plus a preferred return, most commonly 8% annually. Only profits above the hurdle flow into the carried interest waterfall.
The term is also used in corporate finance to mean the minimum acceptable return on a project, often set at or above the company's weighted average cost of capital. In both uses, the idea is the same: returns below the hurdle do not count as success.
How It Works in a Fund Waterfall
A standard distribution waterfall runs in tiers. First, LPs get back all contributed capital. Second, LPs receive the preferred return, say 8% compounded annually on their invested capital. Third comes a GP catch-up tier, where the GP receives most or all distributions until it holds 20% of profits above the return of capital. Finally, remaining profits split 80/20 between LPs and the GP.
Hurdles can be hard or soft. With a hard hurdle, the GP earns carry only on profits above the hurdle; with a soft hurdle plus full catch-up, clearing the threshold lets the GP earn 20% of all profits from the first dollar.
Example
Suppose LPs invest $100 million and the fund returns $150 million after five years. LPs first receive their $100 million back. The 8% preferred return compounded over five years is roughly $47 million (100 x 1.08^5 - 100), so LPs receive that next, leaving about $3 million. With a full catch-up, the GP takes that remaining $3 million and continues catching up on any further proceeds until profits split 80/20 overall.
If the fund had returned only $130 million, the entire $30 million profit would fall short of the $47 million preferred return, and the GP would earn no carry at all.
Why It Matters
The hurdle rate aligns incentives by ensuring managers are paid for genuine outperformance rather than for simply holding capital in a rising market. It is a heavily negotiated term: top-tier venture funds often have no hurdle at all, while LPs in buyout funds treat the 8% preferred return as near-standard.
Private equity interviews frequently include waterfall math, so practice compounding a preferred return and walking through the catch-up tier step by step.
