If you’ve ever wondered how private equity funds decide when to share profits with investors, the answer lies in the hurdle rate. This critical financial benchmark ensures that fund managers (General Partners or GPs) only earn performance fees after delivering a minimum return to investors (Limited Partners or LPs).
In this guide, we’ll break down everything you need to know about hurdle rates, including:
✔ What a hurdle rate is and why it matters in private equity
✔ Hard vs. soft hurdle rates—key differences and examples
✔ How to calculate hurdle rates using WACC, DCF, and IRR
✔ Why 8% is the industry standard for private equity funds
✔ How hurdle rates protect investors and align GP-LP interests
Whether you’re an investor, fund manager, or finance professional, understanding hurdle rates will help you make smarter investment decisions.
What Is a Hurdle Rate?
A hurdle rate is the minimum acceptable rate of return (MARR) an investment must achieve before profits are shared with fund managers. It acts as a performance benchmark, ensuring that investors get their expected returns before GPs earn carried interest (carry).
- Commonly used in private equity, venture capital, and real estate funds
- Ensures alignment of interests between investors and fund managers
- Helps assess risk-adjusted returns before committing capital
Without a hurdle rate, fund managers could earn fees even if investments underperform—putting LPs at a disadvantage.
Preferred Return vs. Hurdle Rate in Private Equity
While the term hurdle rate often gets confused with preferred return, each serves a distinct purpose in private equity structures.
Hurdle Rate → The minimum return a private equity fund must generate before general partners (GPs) receive carried interest.
Preferred Return → A fixed return given to limited partners (LPs) before any profit-sharing occurs with GPs.
For example, a fund might set an 8% hurdle rate, meaning GPs only earn carry on profits exceeding that threshold. If there’s also a preferred return, LPs are guaranteed payment first.
Hard Hurdle Rate vs. Soft Hurdle Rate
There are two primary types of hurdle rates in private equity:
- Hard Hurdle Rate: GPs earn carry only on returns that exceed the hurdle.
Example: If the hurdle is 8% and returns are 12%, carry applies only to the 4% excess. - Soft Hurdle Rate: Once the hurdle is met, GPs receive carry on the entire return amount.
Example: If the fund earns 12% and the hurdle is 8%, carry applies to the full 12%.
Investor Insight: Hard hurdles are more favorable to LPs, while soft hurdles tend to benefit fund managers.
Hurdle Rate vs. IRR: Key Differences
Though both terms assess investment performance, they’re used differently:
- Hurdle Rate: A pre-set minimum return used as a benchmark for profit-sharing eligibility.
- IRR (Internal Rate of Return): The actual annualized return of an investment.
Example: If a fund achieves a 15% IRR with an 8% hurdle rate, the 7% excess may be subject to carried interest—depending on the hurdle structure.
How to Calculate a Hurdle Rate
The hurdle rate calculation often stems from risk-based models. Here’s the basic formula:
Risk-Free Rate: Yield on 10-year Treasury bonds (~4% in 2024)
Risk Premium: Extra return for taking investment risk (e.g., 4–6% for PE funds)
Example: 4% + 4% = 8% Hurdle Rate
This explains why an 8% hurdle rate is the industry standard in private equity.
Why Do PE Funds Use an 8% Hurdle Rate?
- Reflects inflation and market risk premiums
- Mirrors historical equity returns (e.g., S&P 500 averages ~10%)
- Aligns LP protections with GP incentives
If a private equity fund can’t exceed 8%, investors may prefer passive alternatives like index funds.
How Hurdle Rates Protect Investors
- Ensures GPs only earn carry after achieving meaningful performance
- LPs receive returns first, reducing downside risk
- Minimizes misaligned incentives between LPs and GPs
Without hurdle rates, managers could be rewarded even for mediocre results.
Hurdle Rates in Private Equity Waterfall Structures
Hurdle rates play a foundational role in profit distribution through what’s known as the waterfall structure:
- Return of Capital: LPs receive their initial investment
- Preferred Return: LPs earn a fixed return (e.g., 8%)
- Catch-Up: GPs may receive all profits until they “catch up” to their carry percentage
- Carried Interest (80/20 Split): Profits beyond the hurdle are split 80% to LPs, 20% to GPs
This ensures transparent and fair performance-based compensation.
Final Thoughts
Hurdle rates are essential for fair profit-sharing, investor protection, and performance incentives in private equity. By understanding how they work, how they’re calculated, and why 8% is the industry standard, you can make better investment decisions.
Whether you’re an LP evaluating a fund or a GP structuring carry, mastering hurdle rates will give you a competitive edge.
FAQs About Hurdle Rates
1. What is a good hurdle rate?
A 6-10% hurdle rate is common, with 8% being the private equity standard.
2. How do GPs earn carried interest?
Only after the fund exceeds the hurdle rate (e.g., 20% of profits above 8%).
3. Why do PE funds use 8% hurdle rates?
It reflects market risk, inflation, and investor expectations.
4. How are LPs protected by fund thresholds?
Hurdle rates ensure GPs only profit after delivering minimum acceptable returns.
5. How to use hurdle rate in DCF analysis?
The hurdle rate acts as the discount rate to calculate Net Present Value (NPV).
