Hurdle rate and preferred return in private equity

Investors in a private equity fund pay the manager a share of the profit, but only after they have earned a minimum return themselves. That minimum is the hurdle. This page defines it, shows how common each version is, and works one set of numbers through the whole thing so the effect of compounding, the catch-up and the start date is visible. It is part of the fundamentals section and picks up the carry mechanics from the fees and carry page.

Key takeaways

• Hurdle rate and preferred return are two names for the same thing: the return investors must get before the manager’s carried interest¹.
• It is usually 8%² and usually compounded².
• A hurdle does not stop the manager earning carry in a good fund. With a 100% catch-up the manager still ends with the full carry share of the profit if the fund is profitable enough⁵.
• The same sale can pay the manager very different carry depending on how long the money was out. Later exits face a higher hurdle.
• The start date of the clock, and fund borrowing, change the result².

What the hurdle does

Carried interest is a share of profit, and the fund’s documents decide when it becomes payable. The glossary in the ILPA Principles puts the trigger this way: carried interest is payable once investors have recouped their original investment in the fund, plus a defined hurdle rate, if applicable¹. The hurdle rate or preferred return is the internal rate of return a fund must achieve before the manager may receive an increased interest in the proceeds¹. Sponsors typically do not participate in returns until investors receive an amount equal to their original investment plus a minimum return⁴.

The usual order of payment runs through four steps⁶.

Not every fund provides for a hurdle and a catch-up⁶. In the ILPA 2021 sample 16% of funds had no hurdle at all². The IOSCO conflicts report adds that the majority of private equity firms accrue performance pay only on realised profits, and only after investors have received a full return plus a cost-of-money hurdle, after fund costs and fees³. The hurdle is one part of the distribution waterfall, not a free-standing rule.

Hurdle rate, preferred return, IRR and target return

The terms get mixed up, so the table separates them.

The last row matters because “hurdle rate” is also used in corporate finance for the minimum return a project must clear. A fund’s preferred return of 8%² and a firm’s 22% target¹¹ answer different questions. The first is a contract term between investors and manager. The second is an internal underwriting aim, which no investor is promised.

How common and how high

The sources measure different samples, so the numbers are listed with their scope.

Taken together the sources agree on the centre. Eight percent is the standard²⁴, and the spread of hurdles around it runs from six to ten percent⁵. Private equity is the tightest asset class: nearly 80% of private equity funds sit at 8%⁴. Hong Kong’s tax authority treats carry of around 20% of profit above a hurdle rate as the private equity norm⁸. No public benchmark for Asian hurdle rates was found, so the figures stay on the labelled samples.

Compounded, simple, hard or soft

Compounded. Hurdle rates are cumulative and compounded annually⁷, and 78% of waterfalls in the ILPA sample compounded the hurdle². Compounding means the preferred return earns a preferred return itself. Over a longer hold the gap from simple interest widens.

Hard or soft. A soft hurdle lets the manager share in all returns once the hurdle is passed. A hard hurdle lets it share only in the excess⁷. With an 8% hurdle and a 16% cumulative return, a soft hurdle would let the manager share in the full 16% and a hard hurdle only in the excess 8%⁷. ILPA prefers the hard form: carry based only on the portion of profit that exceeds the investors’ preferred return¹, and it suggests a GP may use a hard hurdle to foster alignment¹.

Catch-up. In a soft-hurdle fund the catch-up is what makes the manager whole after the hurdle. Private equity and venture funds usually have a 100% catch-up after payment of the preferred return⁴. Real estate funds are more likely to have a 50/50 catch-up⁴. In the Metrick and Yasuda sample most funds with a hurdle had a 100 percent catch-up and most of the rest 80 percent⁵, and only two funds had a hurdle without any catch-up⁵.

Why the catch-up is important: a worked example

The effect of a hurdle on expected revenue depends greatly on whether there is a catch-up⁵. With a catch-up, the manager still receives the same fraction of profit as long as the fund is sufficiently profitable⁵. The next example shows both halves of that sentence: full carry when the fund is comfortably above the hurdle, less when it is not, and nothing when it is below.

Worked example: one sale, four exit dates (our arithmetic)

All inputs are invented. A fund invests 100 on day one (assumed) and sells the investment for 150 at the end of year 3, 4, 5 or 6 (assumed), so profit is 50 in every case (our arithmetic). The hurdle is 8% compounded². The catch-up is 100% and carry is 20%⁴². There are no fees and no other investments (assumed).

The hurdle amount is 100 multiplied by 1.08 for each year held, and the preferred return is that amount minus 100 (our arithmetic)⁷. With a 100% catch-up and 20% carry, the catch-up needed is one quarter of the preferred return (our arithmetic)⁴. The column on the right shows the hard-hurdle version, where the manager takes 20% only of the profit left after the preferred return¹.

Every figure in the table is our arithmetic on the assumptions above⁵⁷.

Read down the column. At years 3 and 4 the profit left after the preferred return is bigger than the catch-up, so the manager completes the catch-up and ends with 10.00, which is 20% of the 50 profit (our arithmetic)⁵. At year 5 the profit left (3.07) is smaller than the catch-up that would be needed (11.73), so the manager receives only 3.07 (our arithmetic)⁴. At year 6 the hurdle amount of 158.69 is above the 150 sale price and the manager receives nothing, and the investors keep all 150 (our arithmetic)⁵. The sample paper makes the same point at a smaller scale: if a $100M fund with an 8% hurdle earned only $8M or less in profit, all of it would go to the investors⁵.

Two lessons follow. A catch-up turns the hurdle from a deduction into a threshold, because once it is cleared by enough, the manager is back at the full carry share⁵. And a hard hurdle without a catch-up costs the manager more than half its carry in the first two rows, 4.81 against 10.00 and 2.79 against 10.00 (our arithmetic)¹.

Compounding against simple interest

Worked example: four years at 8% (our arithmetic)

On 100 held for four years (assumed), a simple 8% a year would give 32 of preferred return, and 8% compounded gives 36.05 (our arithmetic)⁷. Compounding adds 4.05 over four years (our arithmetic)⁷. The gap grows with the hold, which is why a compounded hurdle is harder for the manager to clear than a simple one of the same headline rate².

When the clock starts

The date the preferred return starts to accrue is a term investors negotiate. ILPA’s principles ask for the preferred return to run from the date capital is called to the point of distribution¹. Where capital comes from a bridging facility secured on uncalled commitments, the preferred return should run from the date the facility is drawn, which is when capital is at risk, and not from the date LPs are later called¹. ILPA’s survey report lists less favourable conventions: starting the clock when the fund uses the contribution rather than when it is paid in, ending it when the fund receives proceeds rather than when it distributes, and leaving gaps when proceeds are recycled². Some funds also stop accruing once capital is returned, so unpaid preferred return no longer compounds².

Worked example: a credit line delays the clock (our arithmetic)

Reuse the numbers above². The fund draws a credit facility to invest 100 on day one (assumed), calls LPs at the end of year 1 (assumed), and sells for 150 at the end of year 5 (assumed).

A one-year difference in the start date moves the carry from 3.07 to 10.00, more than three times as much (our arithmetic)¹². The investors’ money was exposed for five years, and only the first convention counts them. This is why ILPA also asks that subscription lines serve the partnership as a whole, not mainly to enhance reported IRR in order to accelerate carry¹, and that they stay short, for example no more than 180 days and no more than 20% of commitments¹. The survey report suggests LPs negotiate a clean-down of the facility within 12 months². The IRR page shows the same delay raising IRR with the multiple unchanged.

Variants

Not every fund follows the 8% template². The sources show four common departures⁴¹².

The hurdle always has to be read with the whole waterfall: carry and catch-up details can change profit sharing as much as the headline rate⁴. Whole-of-fund waterfalls remain the dominant structure globally², and ILPA asks that carry on recapitalisations be paid only once the full invested capital of the recapitalised investment is realised¹.

Hong Kong: the hurdle in the carried interest tax concession

Hong Kong’s tax authority treats carry of around 20% above a hurdle rate as a common private equity arrangement⁸. The hurdle also appears in the tax concession. A Baker McKenzie review of the 2026 package says the requirement that carried interest be received on fulfilment of a hurdle rate stated in the fund documents will be removed¹⁰. The Financial Secretary’s January 2026 speech lists the same change, removing the certification requirement for funds and the reference to a hurdle rate⁹. Under that change a hurdle would no longer be a condition of the concession. The Hong Kong market page covers the wider tax and fund regime.

Questions to ask of a fund’s terms

These follow the ILPA material above.

• What is the rate, and is it compounded²?
• When does the clock start: call, draw of a facility, or investment¹?
• When does it stop: distribution or receipt of proceeds²?
• Is the catch-up 100%, partial or absent, and is the hurdle hard or soft¹¹²?
• Are credit lines limited in length and size¹?
• Is the waterfall explained in terms a non-lawyer can follow¹?

Limits of this page

The worked examples use invented figures, a single investment and no fees, so they show the mechanics and are not a forecast of any fund. Real waterfalls vary by fund and by asset class⁴. The survey figures come from ILPA’s 2021 report and Goodwin’s 2023 database, and the older Metrick and Yasuda sample covers funds raised before 2007⁵. This is education only. It makes no offer, gives no advice and recommends no fund or manager.