The hurdle is a rate, so the multiple at which carried interest switches on depends on timing, and the band above it belongs to the manager.
Carry switches on at the gross multiple whose IRR equals the hurdle, so the answer depends on timing, not on the multiple alone. On an illustrative fund that draws its capital over four years and returns it over years four to nine, an 8 per cent compounding hurdle is met at 1.48x, and a full catch-up is complete at 1.57x. Between the two, every distributed dollar goes to the manager and the investors' net IRR stays pinned at 8.00 per cent.
Worked in full in How to Read a Limited Partnership Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Investors often carry a single rule of thumb, that carried interest starts somewhere around 1.5 times. It is a coincidence of one timing profile, not a property of the hurdle. The limited partnership agreement states the hurdle as a rate; the multiple at which it bites has to be computed from the cash flows, and it moves by a tenth of a turn for every year the exits slip.
| Term | Value |
|---|---|
| Contributions, years 0 to 3 | 25 a year |
| Distributions, years 4 to 9, share of the total | 10, 15, 20, 25, 20, 10% |
| Preferred return, compounding annually on unreturned capital | 8% |
| Carried interest | 20% |
| Catch-up | Full, 100% to the manager |
The multiple is applied to the distribution profile: at 1.50x the fund pays out 150 over the six years in the proportions shown. That keeps the timing fixed while the outcome changes, which isolates the effect of the multiple.
Switch-on: the multiple M at which IRR(contributions, M × distribution profile) = hurdle
Catch-up complete: the multiple at which the manager holds 20% of total profit
In Excel, put M in one cell, build the distribution row as =M*100*weight, and Goal Seek =IRR(flows) to 0.08 by changing M. Then run the waterfall year by year: hurdle balance, catch-up, split.
The first threshold needs no waterfall at all. Before carry, the investors receive every distribution, so their IRR is the gross IRR, and the hurdle is cleared exactly when the gross IRR reaches 8 per cent. Here that is 1.48x: the 47.7 of profit at that multiple is precisely the preferred return that has accrued on this timing.
The second threshold follows from the catch-up. Once the hurdle is paid, the manager takes everything until it holds 20 per cent of all profit. At 1.57x, profit is 57.1 and the manager has 11.42, which is 20 per cent of it. From there on, each further distribution is split 80/20.
| Gross multiple | Gross IRR | Carry | Manager's share of profit | LP net multiple | LP net IRR |
|---|---|---|---|---|---|
| 1.25x | 4.49% | 0.00 | 0.0% | 1.25x | 4.49% |
| 1.40x | 6.86% | 0.00 | 0.0% | 1.40x | 6.86% |
| 1.48x | 8.00% | 0.00 | 0.0% | 1.48x | 8.00% |
| 1.50x | 8.34% | 2.82 | 5.6% | 1.47x | 8.00% |
| 1.57x | 9.34% | 11.42 | 20.0% | 1.46x | 8.00% |
| 1.60x | 9.74% | 12.00 | 20.0% | 1.48x | 8.36% |
| 1.75x | 11.72% | 15.00 | 20.0% | 1.60x | 10.05% |
| 2.00x | 14.75% | 20.00 | 20.0% | 1.80x | 12.81% |
Between 1.48x and 1.57x the investors' IRR does not move. The extra 9.4 of distributions per 100 contributed goes entirely to the manager. Their multiple even dips, from 1.48x to 1.46x, because higher distributions clear the hurdle earlier and less preferred return accrues; the 8.00 per cent IRR is all the hurdle ever promised. Above 1.57x the waterfall behaves as the headline terms suggest: the manager has exactly 20 per cent of profit at every outcome.
| Distributions | Carry switches on | Catch-up complete |
|---|---|---|
| One year earlier | 1.37x | 1.44x |
| Base | 1.48x | 1.57x |
| One year later | 1.59x | 1.71x |
| Two years later | 1.72x | 1.87x |
Each year of delay adds about a tenth of a turn to the switch-on point. A fund that returns 2.00x two years late still pays full carry of 20.00, but its investors earn 8.93 per cent net against 12.81 on the base timing. The multiple is identical; the hurdle saw the difference.
Without a catch-up, the manager takes 20 per cent only of profit above the hurdle. At 1.60x that is 2.98 instead of 12.00, and the investors' IRR is 9.41 per cent rather than 8.36. At 2.00x the gap narrows to 12.02 against 20.00. A hard hurdle is worth most to investors in exactly the band where funds most often finish.
The common mistake is to read the hurdle as a multiple, or to assume the investors keep 80 per cent of everything above it. Neither holds. The hurdle is a rate, so the multiple at which it bites rises with every year capital stays out. And with a full catch-up, the band just above the hurdle belongs to the manager: an investor modelling a 1.55x outcome as "8 per cent plus 80 per cent of the excess" overstates its own return, because the excess is catch-up.
Check any waterfall output: if the gross IRR is between the hurdle and the catch-up threshold, the investors' net IRR should equal the hurdle to the second decimal. If it is higher, the catch-up is not in the model; if lower, the hurdle is being computed on the wrong base.
Compute the switch-on multiple from the fund's own timing: on this profile 1.48x, with the catch-up complete at 1.57x and the investors pinned at 8.00 per cent in between. The free companion workbooks for the book run the same test on the book's worked fund, and the algebra of the catch-up itself is set out in a related article.
Only for one timing profile. The hurdle is a rate, so the multiple needed to clear it rises the longer capital is out. On an illustrative fund it is cleared at 1.48x; with distributions one year earlier at 1.37x, and two years later at 1.72x. The multiple must be computed from the fund's own cash flows.
With a full catch-up, every dollar distributed after the hurdle goes to the manager until it holds 20 per cent of total profit, so investors' net IRR stays at the hurdle. On the illustrative fund that band runs from 1.48x to 1.57x gross, 9.4 of distributions per 100 contributed, and investors earn 8.00 per cent throughout.
Most just above the hurdle. With no catch-up the manager takes 20 per cent only of profit above the preferred return. At 1.60x that is 2.98 per 100 contributed instead of 12.00, lifting the investors' net IRR from 8.36 to 9.41 per cent. At 2.00x carry is 12.02 against 20.00.
This article is one calculation from How to Read a Limited Partnership Agreement. 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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