Hurdle Rate in Private Funds

A hurdle rate is the minimum annual (or periodic) return a private fund must achieve before its manager begins collecting carried interest (the performance fee). If a fund returns 5% and the hurdle rate is 8%, the manager earns no carried interest that year, even though the fund is profitable. Only gains above the hurdle are shared with the manager, aligning compensation with outperformance and protecting limited partners from fee-sharing on ordinary returns.

Why hurdle rates matter for limited partners

Hurdle rates protect limited partners in a simple way: they ensure that managers don’t take a cut of gains that represent mere inflation-matching or modest market returns. A fund that invests in bonds or index funds and achieves a 5% annual return generates real value. But if the market baseline is 6%, the fund has underperformed, and the manager shouldn’t profit from that underperformance.

Without a hurdle rate, a manager could collect carried interest on any positive return, regardless of whether the fund beat a relevant benchmark or delivered returns commensurate with risk and capital lock-up. A hurdle rate flips the incentive: the manager only earns a bonus when the fund jumps over a predefined bar.

Hurdle rates in practice: a numeric example

Assume a private equity fund has committed capital of $1 billion and a 20% carried interest split (the manager retains 20% of profits above the hurdle). The hurdle rate is 8% annually. In year one:

In Scenario A, the manager earns no carried interest despite positive returns, because the fund underperformed the hurdle. In Scenarios B and C, the manager’s fee rises as outperformance increases, creating a steep incentive to beat the hurdle meaningfully.

Soft hurdle vs hard hurdle

Practitioners distinguish two structures:

Hard hurdle: The manager earns carried interest only on gains above the hurdle. All returns below the hurdle go entirely to limited partners. This is the structure in the example above and is the most common form in private equity and venture capital.

Soft hurdle (or “European” hurdle): The manager can earn carried interest on all gains (including those below the hurdle) once the hurdle is cleared. In other words, once the fund hits the hurdle rate, the manager retroactively claims carried interest on all gains from the beginning of the period, not just on the excess above the hurdle.

Using the example above with a soft hurdle:

• If the fund returns 10%, it has cleared the 8% hurdle. The manager earns 20% on the entire $100M gain ($20M), not just the $20M above the hurdle. LPs net $80M instead of $96M.

Soft hurdles are rarer in modern funds and are increasingly seen as unfavorable to LPs because they dilute returns once the hurdle is crossed. Hard hurdles are now the market standard for most hedge funds, private equity, and venture capital funds.

How hurdle rates are set

Hurdle rates are typically benchmarked to:

• Treasury yields (e.g., the 10-year U.S. Treasury rate at fund inception), reflecting a “risk-free” baseline.
• Treasury plus a spread (e.g., 10-year Treasury + 200 basis points), accounting for the illiquidity and risk premium of private investments.
• LIBOR or SOFR plus a spread, in legacy structures (though LIBOR has been phased out).
• Inflation plus a margin (e.g., CPI + 300 bps), ensuring real return hurdles.
• A fixed percentage (e.g., a fixed 8% regardless of market conditions), common in mature strategies with stable target returns.

The choice reflects the fund strategy and market conditions at inception. A venture capital fund might set a hurdle of 8%, expecting venture returns to substantially exceed that bar. A real estate or infrastructure fund might set a 6% hurdle, reflecting lower risk and more stable cash flows.

Hurdle rates are rarely adjusted during a fund’s life, even if market conditions change dramatically. If Treasury rates crash after inception, a fund with a “10-year Treasury + 200 bps” hurdle will see the hurdle drop, easing the manager’s path to carried interest. Conversely, if rates spike, the manager faces a higher hurdle. This static nature creates occasional tension but protects limited partners from having the goalposts moved mid-game.

Interaction with high-water marks

Hurdle rates and high-water marks operate on different principles but are often paired.

• High-water mark: Prevents double-charging for the same returns across multiple years (e.g., protects against paying fees during recovery from a loss).
• Hurdle rate: Sets a minimum return bar each year (or measurement period) before fees are earned at all.

A fund might require the NAV to exceed the high-water mark and the annual return to exceed the hurdle rate before the manager earns carried interest. If the fund posts a 12% return in a year but is still below its prior peak NAV, the hurdle is cleared, but the high-water mark is not—no carried interest is paid. Both gates must be satisfied.

Negotiating hurdle rates

Hurdle rates are negotiable at fund inception, depending on:

• Manager track record: A manager with a stellar 20-year history may secure a lower hurdle (say, 5%) because LPs believe the manager will beat it. An emerging manager might face a 9% or 10% hurdle.
• Fund strategy: Less volatile strategies (e.g., credit funds) might justify lower hurdles (6%). Highly volatile strategies (e.g., venture) justify higher hurdles (10%+).
• Market conditions: In periods of high Treasury yields, hurdle rates tend to be higher (reflecting higher opportunity cost). In low-rate environments, hurdles compress.
• Competitive pressure: In hot fundraising environments, managers compete by offering lower hurdles or soft hurdles to attract capital.

See also