Hurdle Rate (Preferred Return)
Private Equity glossary · Private Equity Fundamentals
Definition
The minimum annualized return LPs must receive before the GP earns carry, conventionally 8% compounded annually on unreturned capital. Most LPAs use compounding (interest-on-interest): capital called at t_0 and distributed at t_4 accrues preferred at 1.08^4 - 1 = 25.97% (vs. 24% simple). Preferred accrues from the date of each capital call on the weighted-average unreturned balance. Once distributions begin, preferred continues to accrue on the remaining unreturned capital. A fund that returns less than 8% annualized pays zero carry; a fund just above 8% pays proportionally less than 20% during the catch-up region.
Hurdle Rate (Preferred Return) in plain English
Imagine you hand a fund manager your money to invest. The hurdle rate is a promise that YOU (the investor, called the LP) get paid a minimum return first — usually 8% a year — before the manager gets to keep any slice of the profits (their cut is called "carry"). It's like agreeing that a contractor only earns a bonus after the house he built is worth at least a set amount; below that, no bonus. The 8% usually compounds, meaning you earn interest on past interest, so money tied up for 4 years owes you 1.08^4 - 1 = 25.97% total, not a flat 24%. If the fund can't clear 8% a year, the manager earns zero carry; just above 8%, they start earning it gradually.
Also called: Preferred Return
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