Hurdle rate: An explainer for fund managers and investors

Author:

The Carta Team

Read time:

12 minutes

Published date:

November 3, 2025

Hurdle rate outlines the minimum return a private equity fund must achieve before the general partner can share in the profits, crucial for understanding profit distribution and calculation methods.

What is a hurdle rate?

A hurdle rate is the minimum required rate of return that a fund must achieve. It serves as a benchmark for evaluating the fund’s overall performance.

For limited partners (LP), the investors in the fund, the hurdle rate represents their minimum acceptable baseline return. It's essentially the cost of capital they demand from the fund. The primary function of the hurdle rate is to ensure compensation to the LP for using their capital; it acts as their minimum required rate of return. This compensation ensures LPs have downside protection, as they must be paid this minimum rate first.

For general partners (GP), the fund managers, the hurdle rate is merely the threshold to eligibility for carried interest (performance-based compensation). Their primary incentive is to maximize returns above the hurdle rate, as they only get paid on that profit. For GPs, an investment typically needs a multiple of 2-3x or an internal rate of return (IRR) of 15-20% or more to be considered intrinsically attractive.

What is a hurdle rate in private equity?

In private equity (PE), the hurdle rate is the minimum rate of return a fund (portfolio) level must achieve before its managers (GPs) can earn carried interest.

This rate is a foundational term, negotiated at the very beginning of a fund’s life and formally defined in the core legal document, the limited partnership agreement (LPA).

Fund-level vs. deal-level calculations

It’s important to note the distinction: The hurdle rate is typically calculated at the fund (portfolio) level, not per individual deal, especially under the whole-fund (European) waterfall approach.

• Fund level: The total fund return (to LPs) must beat the hurdle for carried interest to accrue to the GP. Individual investments may do better or worse, but only the aggregate return matters for triggering the GP’s payout.

• Deal level: Separately, individual investments or portfolio company acquisitions often have their own minimum acceptable IRR (discount rate) used by the GP in the investment decision process. This deal-level hurdle reflects the opportunity cost, risk, and inflation specific to that project, but it is distinct from the fund-level hurdle for carried interest.

Aligning incentives

The primary purpose of a hurdle rate is to align the interests of the fund’s managers with those of its LPs. The hurdle rate ensures that the LPs earn a baseline profit on their investment before the GP can share in the fund’s profits.

This baseline profit is also commonly called the preferred return. It acts as a safeguard for LPs, confirming that their capital must first perform at an agreed-upon level before the manager is rewarded.

How is a hurdle rate determined?

A hurdle rate isn’t calculated with a universal formula. Instead, the GP and LPs determine it through a combination of market conventions and direct negotiation during the fund formation process. The final rate reflects a balance of several factors. These factors help establish a rate that is fair to both parties and competitive in the market.

What is a typical hurdle rate?

Typically, PE funds set a contractual hurdle rate (often around 8%) which LPs must receive before the GP is eligible to earn carried interest, usually a percentage of profits above the hurdle.

How does the hurdle rate impact the distribution waterfall?

The hurdle rate is a critical trigger within the fund's distribution waterfall. The waterfall is the mechanism defined in the LPA that dictates the precise order in which cash from investment profits is distributed to LPs and the GP. The hurdle rate determines when the flow of money shifts from primarily repaying investors to allowing the GP to share in the profits.

A typical waterfall follows four standard tiers:

• Return of capital: The fund returns all contributed capital to the LPs, ensuring that LPs are made whole before any profits are considered or shared.

• Preferred return (the hurdle): After all capital has been returned, the LPs continue to receive all distributions until they have earned their baseline profit. This profit is calculated based on the hurdle rate.

• GP catch-up: In a traditional PE fund structure, the GP receives a catch-up distribution. Once the LPs have received their capital back plus their full preferred return, the waterfall shifts significantly.

• Carried interest split: The remaining profits are split, and the unrealized portion of these profits contributes to the fund's residual value to paid-in capital (RVPI).

European vs. American waterfall

The distribution waterfall's structure can be categorized primarily by how the hurdle rate is applied over the fund's life:

• European waterfall (whole fund): The GP can only receive carried interest after the entire fund has repaid 100% of its capital and generated the preferred return for the LPs.

• American waterfall (deal-by-deal): The GP can receive carried interest on any individual investment that generates a profit, even if other investments in the portfolio are still underperforming or have not yet returned capital to LPs.

Understanding the GP catch-up

The catch-up is a key part of the waterfall. It is the phase where the GP receives a distribution to meet their target profit share, reflecting that the GP is junior to the LPs in the waterfall. The GP must wait for the LPs to achieve their full preferred return before they can begin to earn carried interest.

What are the common hurdle rate calculation methodologies?

The LPA specifies exactly how the hurdle rate is calculated. The chosen methodology can have a significant impact on the timing and amount of final distributions from liquidity events, making it another key point of negotiation.

There are two primary approaches to calculating the preferred return:

• Compounding interest rate (Most common): The preferred return accrues over time on the amount of LP capital that is still invested in the fund and has not yet been returned.

• Fund's overall net IRR: The fund's overall net IRR (one of several key fund performance metrics) must exceed the hurdle rate.

Hard hurdle vs. soft hurdle

Another critical distinction defined in the LPA is whether the hurdle is "hard" or "soft." This choice directly affects the total amount of carried interest the GP can earn and represents a fundamental difference in how the GP is rewarded for performance.

• Hard hurdle (more favorable to LPs): The GP earns carried interest only on the profits that are above the hurdle rate.

• Soft hurdle (more favorable to the GP): Once the fund's return clears the hurdle rate, the GP earns carried interest on all profits, including the profits that were generated below the hurdle.

How does the hurdle rate compare to IRR?

While IRR measures the actual annualized return generated, the hurdle rate is the minimum acceptable rate of return set in advance. The easiest way to understand the difference is to think of them as a goal versus a result.

• For the LPs and the GP's carry: If the fund's final net IRR is greater than the fund's hurdle rate, the performance fee is triggered, and the GP is eligible to earn carried interest.