Fund formation and first-time fund managers
How do hurdle rates and catch-up work in a fund?
Short answer
A hurdle rate is the minimum return investors receive before the manager shares in profits. A catch-up comes after the hurdle and lets the manager receive extra distributions until it has its full carry share of total profit. Both are negotiated terms, and many sponsors talk to a securities attorney about the waterfall language in their fund documents.
Where the hurdle sits in the payout order
When I hear people argue about fund terms, the hurdle is usually where it starts. In most funds the limited partners get their capital back first. Then they receive a preferred return, and that preferred return is the hurdle. Only after that does the general partner begin to share in profits through carried interest. The hurdle protects the investor. It says the manager is not paid for performance until investors have earned a set minimum.
The right number depends on the asset. On a joint venture webinar we hosted, I raised the point that many sponsors use a preferred return in the 7 to 8% range for development deals.
"Many times people use a 7 to 8% preferred return in development, because maybe the returns are a little bit higher."
A guest answering for the LP side said 6 to 8% was typical. They said it could go up to 12% depending on the deal. They added that they don't really go that high anymore, even on a first deal.
This clip covers the hurdle rates investors expect in joint venture and co-GP deals.
Summary and key takeaways from this video
What the catch-up does after the hurdle is cleared
A catch-up is a term that sits right after the hurdle. Without one, the manager only shares in profit above the hurdle. With a full catch-up, the manager then receives most or all of the next distributions until it has received its carry percentage of total profit, including the slice that went to the hurdle. After that, profits split at the agreed carry. A partial catch-up gives the manager a larger than normal share for a while instead.
Here is a simple hypothetical. Say a fund has an 8% preferred return and a 20% carry. With no catch-up, the manager earns 20% only on profit above the 8%. With a full catch-up, a strong enough year brings the manager to 20% of all profit. Whether a fund has a catch-up, and how fast it works, is a negotiated term. Investors should read it closely.
Hurdles also move with the market
People also use the word hurdle for the return a project must clear to be worth doing. In an interview with a Midwest multi-family office, the guest said the public markets had repriced and private real estate would follow. Their view was that hurdle rates for any real estate project would go higher because expected returns on the public side were much higher. For a new build the bar rises, so fewer projects pass the test.
This interview shows how an investor thinks about higher required returns on new real estate projects.
Hurdles can also be used as a way to share risk. A guest on our co-GP webinar described a deal where the partner gave them all the returns above a very high hurdle. They said they never would have imagined making twice as much. They had underwritten the project conservatively. They described it as the partner's way of de-risking their own capital.
The point is that hurdle and catch-up terms shape who bears risk and who gets paid first. Compare the full waterfall, not just the headline preferred return. This page is general education and not legal advice. Many sponsors talk to a securities attorney about these terms before they show them to investors.
More from my talks
Hurdles are also a tool for attracting capital, not only a protection for investors. I have suggested that a manager who wants to bring in direct investors can make the fund side more alluring through better terms. That can mean a lower management fee, more performance-based pay, and sometimes a higher hurdle or preferred return. The idea is to look more aligned with the investor, and then offer both the fund and the direct deal. When you set your hurdle, think about how it reads to the person across the table and not only what the waterfall pays you.
"And then you just incentivize them by having slightly better deal terms on the fund side. And people could go straight to the fund and just make it more alluring, more performance based, lower management fee, somehow more aligned, maybe a higher hurdle, higher preferred return, perhaps. And then do both."
Facts and figures
- A webinar host noted that many sponsors use a 7 to 8% preferred return in development deals.
- A guest on the LP side said hurdles run 6 to 8% and can reach 12% depending on the deal.
- A Midwest multi-family office guest said hurdle rates for new real estate builds would rise because public market expected returns were much higher.
Sources
From Richard C. Wilson's Centimillionaire Strategies YouTube channel: Joint Venture & Co-GP Webinar - How to Close Deals with Peers & Partners in the Family Office Club, Midwest Multi-Family Office Investor Mandate Interview on Opportunity Zones & Fund Manager Investing. Quotes come from the video captions, lightly edited for readability. Figures are the speakers' own estimates and experience.
General education only. Not legal, tax or investment advice.
Talk to a securities attorney to explore options around waterfall and catch-up terms, fund document language and investor distribution terms. Do not use AI to write your own legal agreements.
Next moves
- Write out the full payout order from return of capital to final split.
- Pick a preferred return that fits your asset type and test it against comparable deals.
- Decide if you want no catch-up, a partial one or a full one.
- Run a simple example with real numbers so investors can see each tier.
- Consider talking to a securities attorney about the waterfall language.
More questions on this
Is a hurdle rate the same as a preferred return?
In many funds the two are used to mean the same thing. The preferred return is the minimum annual return investors receive before the manager shares in profit. Check the documents, since some funds define them separately.
Does every fund have a catch-up?
No. It is a negotiated term. Some funds have a full catch-up, some a partial one and some none at all.
What preferred return is typical in a development deal?
On our webinar, the host noted that 7 to 8% is common in development. A guest on the LP side said 6 to 8% and up to 12% depending on the deal.
Related questions
- How much capital do I need for a first close?There is no single number.
- What is a rolling fund and how does it work?A rolling fund is a structure where investors subscribe in recurring periods, usually each quarter, instead of everyone committing at one final close.
- How do I form a Delaware limited partnership for a fund?Many sponsors work with an attorney on the state filings and a limited partnership agreement.
- How do I choose an auditor for my fund?Choose an auditor that already audits funds like yours, is independent from your team and your administrator, and can finish on a timeline your investors accept.
Work through it with the data room checklist. See all fund formation and first-time fund managers resources.