The preferred return is the term a first-time manager is most tempted to sweeten. Here is what two extra points of hurdle cost in carry, outcome by outcome.
Two extra points of hurdle cost a manager nothing in a fund that disappoints or one that does very well, and almost everything in between. On an illustrative 300 million value-add fund with a full catch-up, a 10 per cent preferred return instead of 8 cuts probability-weighted carry from 48.60 to 34.49 million, 29.0 per cent less. To earn the same expected carry at 10 per cent the fund would need to be 422.7 million, 40.9 per cent larger.
Worked in full in Raising a Real Estate Fund by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A first-time manager competing for allocations looks for a term that signals alignment, and the hurdle is the obvious one: it costs no fee income, the investor sees a bigger number, and with a full catch-up the manager still ends up with 20 per cent of the profit "if the fund performs". The last clause is where the cost hides. Whether the catch-up completes depends on the outcome, and the outcomes a value-add fund actually spends most of its probability on are exactly where the hurdle bites.
All figures in millions and illustrative. To isolate the hurdle, all equity is drawn at the start and management fees are left aside; they do not depend on the hurdle.
| Term | Value |
|---|---|
| Equity | 300 |
| Income distributed in years 1 to 5, 3% of equity | 9.0 a year |
| Exit | Year 6 |
| Waterfall | European, full catch-up, 80/20 |
| Preferred return, compounding annually | 8% or 10% |
1. What LPs must receive at exit before the GP gets anything. Their equity grown at the hurdle for six years, less the interim income grown at the hurdle from each payment date.
Required at exit = 300 × (1 + h)6 − Σ 9.0 × (1 + h)6 − t, t = 1 to 5
At 8%: 419.04. At 10%: 471.03.
Excel: =Equity*(1+h)^6-SUMPRODUCT(Income,(1+h)^(6-Years))
2. The catch-up. The preferred profit is the required exit plus the 45.0 of income less the 300 of equity: 164.04 at 8 per cent, 216.03 at 10. A full catch-up gives the GP a quarter of that, so that it then holds 20 per cent of all profit: 41.01 and 54.01.
3. The band where the hurdle matters. Carry starts when total distributions reach the required exit plus the income, and is complete when they also cover the catch-up:
| Hurdle | Carry starts | Catch-up complete |
|---|---|---|
| 8% | 1.547x | 1.683x |
| 10% | 1.720x | 1.900x |
Below 1.547x neither fund pays carry. Above 1.900x both pay a full 20 per cent. All the difference lives between those two multiples.
The probabilities are an illustrative spread for a value-add strategy whose expected gross multiple is 1.860x. The gross IRRs include the interim income.
| Gross multiple | Gross IRR | Probability | Carry at 8% | Carry at 10% | Cost of 10% |
|---|---|---|---|---|---|
| 1.50x | 7.4% | 10% | 0.00 | 0.00 | 0.00 |
| 1.70x | 9.8% | 25% | 42.00 | 0.00 | 42.00 |
| 1.85x | 11.4% | 30% | 51.00 | 38.97 | 12.03 |
| 2.00x | 12.9% | 25% | 60.00 | 60.00 | 0.00 |
| 2.30x | 15.6% | 10% | 78.00 | 78.00 | 0.00 |
| Expected | 48.60 | 34.49 | 14.11 |
At 1.70x the 10 per cent hurdle takes the whole of a 42.00 carry. At 1.85x the exit of 510.0 first pays LPs 419.04 at 8 per cent, leaving 90.96 to run through the catch-up; at 10 per cent LPs take 471.03 and only 38.97 is left, all of it catch-up. Weighted, the higher hurdle costs 14.11 million, 29.0 per cent of expected carry.
The fund-size equivalent is the useful number in a fundraising discussion. Expected carry per million of equity falls in the ratio 34.49 to 48.60, so the 10 per cent fund must raise 422.7 million to earn what the 8 per cent fund earns on 300. On carry alone, if the better hurdle wins 122.7 million of extra commitments it pays for itself; if it wins a third of that, it does not. Fees on the extra capital lower that bar somewhat, which is why the comparison belongs in the full GP economics.
The same money, in the same outcomes. At 1.70x the LP IRR rises from 8.16 to 9.78 per cent; at 1.85x from 9.55 to 10.00. At 1.50x it is 7.43 per cent under both terms, and at 2.00x it is 10.86 under both. An investor reading the higher hurdle as protection in a bad outcome is wrong: in a bad outcome there is no carry to protect against. It is a transfer in the middling outcomes, which is where most funds land.
Comparing the two hurdles only at the target return. If the deck shows 2.00x, both pay 60.00 of carry and the higher hurdle looks free. The comparison has to run across the distribution of outcomes the manager actually believes in, and the GP economics need to include the year-by-year fee income too, as in how much a real estate fund manager earns from fees and carry. The second mistake is ignoring the catch-up: with no catch-up the higher hurdle costs carry at every outcome above the switch-on point, and a partial catch-up widens the band in which it bites.
The book takes a manager from strategy and track record through terms to first close, and the free workbook for this case runs the raise on a calendar to show what each slip in capital costs.
Value-add and opportunistic closed-end funds have most often offered around 8 per cent, with some core-plus funds lower and some first-time or niche managers offering more to stand out. Treat any level as illustrative. On the 300m fund worked here, moving from 8% to 10% raises the gross multiple at which carry starts from 1.547x to 1.720x.
Not with a full catch-up. Once the catch-up completes the GP has 20% of all profit whatever the hurdle: at 2.00x both versions of the illustrative fund pay 60.0m of carry. The cost of the higher hurdle sits entirely in the middle band, between 1.547x and 1.900x, where at 1.70x it takes all 42.0m of carry.
Only what the GP loses, and only in the middle outcomes. At 1.70x the LP IRR in the illustrative fund rises from 8.16% to 9.78%; at 1.85x from 9.55% to 10.00%. Below 1.547x neither hurdle pays carry and above 1.900x the catch-up equalises them, so the LP gain is zero in both tails.
This article is one calculation from Raising a Real Estate Fund. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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