Hurdle Rate (Preferred Return)

Mechanism

The hurdle rate sits inside the distribution waterfall. The ILPA Model LPA Term Sheet (whole-of-fund version) defines the preferred return as an annual rate of return, compounded annually and calculated daily on each capital contribution, running from the date the partnership receives the contribution to the date of distribution. Proceeds then move through four tiers:

1. 100 percent to the limited partner until it has received back its capital contributions.
2. 100 percent to the limited partner until it has received the preferred return.
3. A catch-up tier, which the term sheet drafts as a bracketed 80 percent to the general partner and 20 percent to the limited partner until the general partner has received 20 percent of the distributions made under the preferred-return and catch-up tiers.
4. A final split of 20 percent to the general partner and 80 percent to the limited partner.

The accrual formula is simple. Preferred return owed equals contributed capital multiplied by one plus the hurdle rate, raised to the number of years outstanding, minus the contributed capital.

Worked Example

Take a hypothetical limited partner that contributes $10,000,000 to a vehicle with an 8 percent compounded hurdle and a carried interest rate of 20 percent. Five years later the investment is sold and $20,000,000 is available to distribute, a gross multiple of 2.0x.

• Preferred return owed: $10,000,000 times 1.08 to the fifth power, minus $10,000,000, which is $4,693,281.
• Tier 1 returns the $10,000,000 of capital and tier 2 pays the $4,693,281 preferred return, leaving $5,306,719.
• Tier 3 is the catch-up. The general partner receives 80 percent of each dollar until it holds 20 percent of the preferred return plus catch-up, which takes $1,564,427 of proceeds: $1,251,542 to the general partner and $312,885 to the limited partner.
• Tier 4 splits the last $3,742,292, giving the general partner $748,458 and the limited partner $2,993,834.

The general partner receives $2,000,000 in all, exactly 20 percent of the $10,000,000 profit, and the limited partner receives $18,000,000. The hurdle delayed carry but did not reduce it, because the catch-up restored it.

Hard Hurdle Rate Versus Soft Hurdle Rate

The two types differ in what happens after the limited partner clears the hurdle. With a soft hurdle, as in the example above, the catch-up lets the general partner share in all profit once the preferred return is met. With a hard hurdle there is no catch-up, and carried interest applies only to the profit above the preferred return. On the same $20,000,000 of proceeds, a hard hurdle pays the general partner 20 percent of $5,306,719, which is $1,061,344, and leaves the limited partner $18,938,656. Page 10 of the ILPA Principles 3.0 says carried interest should ideally use a hard hurdle, so that carry is based only on the portion of profit exceeding the preferred return.

What It Means for a Limited Partner

The hurdle rate is a priority claim, and it is not a promised return. If the example investment had returned $14,000,000, the limited partner would take all of it, because the $4,000,000 of profit would still fall short of the $4,693,281 owed, and the general partner would earn nothing. Three diligence points follow. First, ask whether the rate compounds. The ILPA 2021 market-terms report found a compounded preferred return in 78 percent of the funds it sampled, an 8 percent hurdle in 67 percent, and no hurdle at all in 16 percent. Second, ask when accrual starts. ILPA Principles 3.0 say that when a subscription line funds an investment, the preferred return should run from the date the line is drawn, not the later date capital is called. Third, ask whether the waterfall is whole-of-fund or deal-by-deal, since that decides how soon carry can be paid.

In Life Sciences and Healthcare

Compounding makes the hurdle heavier as holding periods lengthen, and biopharma holding periods are long. A BIO, Informa and QLS Advisors study of 2011 to 2020 development programs found an average of 10.5 years from Phase I to regulatory approval, with only 7.9 percent of Phase I candidates reaching approval. An 8 percent hurdle compounded over 10.5 years requires a gross multiple of about 2.24x before any carry is earned, against 1.47x over five years. A therapeutics investor should therefore read the hurdle together with the fund term and the expected time to a liquidity event.

Frequently Asked Questions

What is a hurdle rate in private equity?

A hurdle rate in private equity is the minimum annual return, called the preferred return, that limited partners must receive on their contributed capital before the general partner earns carried interest. The ILPA model term sheet expresses it as a percentage compounded annually and calculated daily from the date each capital contribution is received until it is returned.

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

A soft hurdle lets the general partner catch up and share in all profit once the preferred return is paid, while a hard hurdle pays carried interest only on profit above the preferred return. In the $10,000,000 example, the soft hurdle pays the general partner $2,000,000 and the hard hurdle pays $1,061,344. ILPA prefers the hard hurdle.

What hurdle rate is standard?

Eight percent is the common figure. The ILPA 2021 report on market fund terms found an 8 percent preferred return in 67 percent of the funds sampled, and found no hurdle in 16 percent. The sample was drawn from limited partner survey data, so a given fund should be compared with its own strategy. The J-curve and commitment-pacing model shows when distributions begin.

Related Reference

The hurdle rate is one tier of the economics discussed in growth equity. Related entries: Carried Interest, Distribution Waterfall and Management Fee.