Hurdle Rate

A hurdle rate sets a return threshold for performance compensation. In private funds it is usually called the preferred return and is often set at 8% per year on contributed capital, compounding as specified in the LPA. In hedge funds a hurdle may be a fixed rate or a benchmark such as a short-term interest rate, applied alongside a high-water mark.

Hurdles are either soft or hard. With a soft hurdle, once the threshold is cleared the manager is paid on all profits, typically through a catch-up tier. With a hard hurdle, the manager earns only on returns above the hurdle.

Pitfalls include compounding the hurdle on the wrong basis (simple versus compound, annual versus daily), applying it to the wrong capital base, failing to reset it correctly after distributions, and misreading whether the hurdle is soft or hard.

Example

LPs contribute $10M and the fund earns $3M of profit in one year. With an 8% hurdle, LPs first receive $0.8M. Under a soft hurdle with full catch-up and 20% carry, the GP earns 20% of the full $3M, or $0.6M. Under a hard hurdle, the GP earns 20% only of the $2.2M above the hurdle, or $0.44M.