Hurdle Rate
A hurdle rate is the minimum return a fund must deliver to its investors — typically 8% a year — before its manager receives any carried interest; the same term names the return a company requires before approving an investment or an acquisition. In the fund it protects investors from paying for returns they could have earned elsewhere; in the company it is the cost of capital with a margin, and the number an acquisition case must clear.
- Also known as
- Preferred return, Hurdle, Minimum return
- Used at
- fund waterfalls (the "preferred return"); corporate investment appraisal; acquisition committees; performance-fee calculations in hedge funds (as a benchmark hurdle)
- Binding
- in a fund, the limited partnership agreement; in a company, the board's policy
- Typical fund hurdle
- 8% for buy-out and infrastructure funds, often none for venture (whose returns are expected to dwarf it); a "hard" hurdle pays carry only on returns above it, a "soft" hurdle with a catch-up pays carry on all profit once it is passed
- Typical corporate hurdle
- the weighted average cost of capital plus 2–5 points — 10–15% for a fintech acquirer, higher for riskier deals; private equity's deal hurdle is the 20–25% IRR its fund needs
- Parties
- fund managers and investors; boards, investment committees and the deal teams whose cases must clear the number
How a hurdle rate works in practice
In a fund, the waterfall pays the limited partners their capital back and then a preferred return — 8% a year compounded on the capital they had at risk — before the general partner receives carry. If the fund returns less than 8% a year, the GP receives nothing beyond its fee. If it returns more, the catch-up pays the GP its 20% of the whole profit and the split continues 80/20. The hurdle is the reason a fund that returns 1.3× over eight years pays its manager little, and a fund that returns 2× pays it a fortune.
In a company the hurdle is the board's discipline. An acquisition's forecast cash flows are discounted at the hurdle rate; if the present value exceeds the price, the deal clears; if not, it is declined or repriced. The rate is the cost of capital plus a margin for the errors every forecast contains, and boards that set it by ambition rather than by cost approve too little or too much. A fintech acquirer at a 12% hurdle looking at a target whose synergy-adjusted return is 11% has a decision to make, and the honest answer is usually no.
Private equity's version is stricter: a deal is done if the fund's model shows the IRR its own investors expect — 20–25% — which is why sponsors' prices are lower than strategics' and why they lose auctions to buyers with a 10% hurdle and a synergy case.
Example
A €500m fund with an 8% hurdle and a full catch-up returns €900m over eight years. Investors receive €500m of capital and then the preferred return — about €190m, 8% compounded on the invested balance over the fund's life — €690m in all, before the GP sees carry. The catch-up then pays the GP until it has 20% of the profit to date, and the remainder is split 80/20; the GP ends with €80m, 20% of the €400m profit. Had the fund returned €620m — 1.24×, an IRR near 4% — the investors would have received all of it and the GP nothing beyond its fees. The hurdle turned a mediocre fund into a fee-only fund, which is what the investors negotiated it for.
Common mistakes
- Venture funds without hurdles that pay carry on a 1.5× return the public market would have matched. - A soft hurdle with a full catch-up read by investors as a hard one. - Corporate hurdles set by tradition (15% since 1995) rather than by the current cost of capital. - Deal teams building the case to clear the hurdle rather than to describe the deal. - Comparing a sponsor's 22% IRR hurdle with a strategic's 11% and concluding the sponsor is greedy; the sponsor has no synergies and its investors have their own hurdle.