Carried interest is the manager's share of profits. A hurdle rate means LPs receive a minimum return before carry is paid; a catch-up then lets the manager receive its full share once returns clear the hurdle.
14 min read · Level 5
I think hurdle rates are marketed as stronger LP protection than they usually are. With a full catch-up, a hurdle protects LPs mostly in funds that barely beat their capital back, which is useful but narrow. The waterfall type and the enforceability of clawbacks often matter more to LPs than the headline hurdle.
Carried interest, typically 20% of profits, is paid to the manager when the fund makes money. Many funds add a hurdle: a preferred return to LPs, often 8% a year, before carry applies. A catch-up then lets the manager receive distributions until it has its full share of profits.
A whole-fund (European) waterfall. A 100,000,000 fund returns 250,000,000. For simplicity, assume the preferred return over the fund's life is 8% compounded over 5 years of average holding: 100,000,000 x (1.08^5 - 1) = about 46,930,000.
Step To LPs To manager 1 Return of capital 100,000,000 2 Preferred return 46,930,000 3 Catch-up until manager has 20% of profits 11,730,000 4 Remaining 91,340,000 split 80/20 73,070,000 18,270,000 Total 220,000,000 30,000,000
The manager ends with 30,000,000, exactly 20% of the 150,000,000 profit. With full catch-up, the hurdle does not reduce carry in a strong fund.
Where the hurdle matters. If the fund returns 130,000,000, profit is 30,000,000, below the 46,930,000 preferred return. LPs receive all 130,000,000 and the manager receives no carry. Without a hurdle, the manager would take 20% of 30,000,000 = 6,000,000.
Deal-by-deal (American) waterfall. Carry is paid on each successful exit as it happens, rather than after LPs get all capital back. Managers receive carry earlier, and a clawback provision is meant to return excess carry if later losses mean the manager was overpaid. Clawbacks can be hard to enforce in practice.
Because the order of distributions changes when the manager is paid and whether LPs are protected in mediocre funds. The same 20% carry can mean very different things depending on the hurdle, catch-up and waterfall type.
It also shows that hurdles are often overestimated as protection. With a full catch-up, they mainly matter in funds that return only modestly above capital.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Early carry under a deal-by-deal waterfall. A fund makes an early 30,000,000 profit on one deal and pays 6,000,000 carry immediately. Later deals lose 25,000,000. Overall fund profit is 5,000,000, so total carry should be 1,000,000.
Carry paid early 6,000,000 Carry justified 1,000,000 Clawback owed 5,000,000
The manager is obliged to return 5,000,000, but may have distributed it to individual partners years earlier, paid tax on it, or have limited ability to repay. Whole-fund waterfalls avoid much of this by paying carry only after LPs recover capital.
Assuming a hurdle rate means the manager earns less carry in a successful fund, or overlooking the difference between whole-fund and deal-by-deal carry.
Read the percentage, the preferred return and whether catch-up is full or partial.
Confirm whether carry is calculated on the whole fund or deal by deal.
Run the waterfall at, say, 1.3x and 2.5x to see where the hurdle matters.
Check whether clawbacks are guaranteed by partners, escrowed or only promised.
When evaluating the carried interest terms of any private fund.
Do not rely on the simplified preferred return calculation for a real fund. Actual calculations depend on the timing of every capital call and distribution.
The Institutional Limited Partners Association's published principles for private equity fund terms have expressed a preference for whole-of-fund (European) waterfalls and robust clawback provisions to align managers' carried interest with LPs' overall returns.
Institutional investors treat the waterfall structure as a key alignment term. Individual LPs should read it just as closely.
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