Hurdle rate

A hurdle rate, also called a preferred return, is a term of the fund rather than of any single deal. Before the manager receives carried interest, the investors must first receive their capital back plus a stated annual return on it. Around 8% a year is the long standing convention, and it is expressed as a rate rather than as a multiple.

It matters to how an individual investment is underwritten even though it is not tested at the deal level. An investment expected to return roughly the hurdle earns the manager nothing and pays the investors only the promised minimum, while consuming fund capacity for years. That is why sponsors underwrite to a target comfortably above it rather than to it.

It also explains a piece of language that sounds harsh the first time you hear it. A deal that returns the money invested is called a failure rather than break even, because the capital was tied up for five years and produced nothing for anyone. Break even at the fund level is the hurdle, not cost.

Do not confuse the fund hurdle with the equity waterfall inside a single portfolio company, where preferred instruments, rolled over shareholders and management incentive equity each have their own priorities. Both are described as preferences and they operate at different levels, so an answer that mixes them reads as memorised.