A year-by-year ledger of contributed capital and accrued preferred return, and the three shortcuts that misstate it by 7 to 10 units.
Compound each capital contribution at the hurdle rate from the day it was called, and subtract each distribution compounded from the day it was paid. What is left is the amount LPs must receive before the general partner shares in profit. On an illustrative fund that calls 40, 30 and 30 and distributes 50 in year 4, an 8 per cent compounding preferred return means LPs need 90.05 in year 6: 50 of capital and 40.05 of preferred return.
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 →
The preferred return, or hurdle, is the first tier after the return of capital in a standard distribution waterfall, and it is rarely stated as an amount. The limited partnership agreement gives a rate, a basis and a compounding convention; the amount depends on when every contribution and every distribution happened. The calculation is a running balance, and building it once makes most waterfall disputes easy to settle.
| Year | Contribution | Distribution |
|---|---|---|
| 0 | 40 | 0 |
| 1 | 30 | 0 |
| 2 | 30 | 0 |
| 4 | 0 | 50 |
| Total | 100 | 50 |
Carry one balance: unreturned capital plus unpaid preferred return. Each year it grows at the hurdle, rises with contributions and falls with distributions.
Closingt = closingt−1 × (1 + 8%) + contributiont − distributiont
In Excel, with the prior closing balance in E2, the contribution in C3 and the distribution in D3: =E2*(1+8%)+C3-D3, copied down.
| Year | Pref accrued | Contribution | Distribution | Closing balance |
|---|---|---|---|---|
| 0 | 0.00 | 40 | 0 | 40.00 |
| 1 | 3.20 | 30 | 0 | 73.20 |
| 2 | 5.86 | 30 | 0 | 109.06 |
| 3 | 8.72 | 0 | 0 | 117.78 |
| 4 | 9.42 | 0 | 50 | 77.20 |
| 5 | 6.18 | 0 | 0 | 83.38 |
| 6 | 6.67 | 0 | 0 | 90.05 |
The pref accrued column sums to 40.05. Distributions are applied to capital first in a European, whole-fund waterfall (how that order differs from the deal-by-deal American one is set out in European vs American waterfall: the clawback), so the year 4 payment of 50 returns half the capital, and in year 6 the balance splits into 50 of unreturned capital and 40.05 of preferred return.
40 × 1.5869 + 30 × 1.4693 + 30 × 1.3605 − 50 × 1.1664
= 63.47 + 44.08 + 40.81 − 58.32 = 90.05
Each factor is 1.08 raised to the number of years from the cash flow to year 6. Paying LPs exactly 90.05 in year 6 gives them an IRR of 8.00 per cent: the preferred return is the distribution that brings the LPs' IRR up to the hurdle.
Two definitions in the agreement decide what goes into the contribution column. The first is whether contributed capital includes management fees and fund expenses, which it usually does, so that the investors earn the hurdle on every unit they sent, not only on the part that was invested. The second is how a subscription line is treated: if the pref runs from the date the LPs actually fund rather than the date the fund drew on the facility, borrowing shortens the accrual and lowers the amount owed.
| Variant | Required in year 6 | Of which pref |
|---|---|---|
| 6 per cent hurdle | 78.58 | 28.58 |
| 7 per cent hurdle | 84.18 | 34.18 |
| 8 per cent hurdle, distribution in year 4 | 90.05 | 40.05 |
| 10 per cent hurdle | 102.60 | 52.60 |
| 8 per cent, the 50 paid in year 2 | 80.35 | 30.35 |
| 8 per cent, the 50 paid in year 6 | 98.37 | 48.37 |
| 8 per cent, simple interest on capital outstanding | 82.80 | 32.80 |
Two lessons sit in the table. Each point of hurdle is worth roughly 6 units of pref on this profile, more at higher rates because of compounding. And timing matters as much as the rate: the same 50 paid two years earlier saves 9.70 of pref, more than a point of hurdle does. A GP who returns capital early is, in effect, negotiating the hurdle down.
Simple or compound. A simple pref accrues 8 per cent only on capital outstanding: 40, 70, 100, 100, 50 and 50 in the six years, 410 of capital-years, so 32.80 in total. That is 7.25 less than the compounding version. Most agreements compound, but the word "compounded" is the one to look for, along with the frequency, which is the subject of how much quarterly compounding adds.
Three shortcuts appear in practice, and each misstates the hurdle by more than the difference between two competing term sheets.
Build the balance: last year's balance times one plus the hurdle, plus contributions, minus distributions. Check it against the future values, and check that paying the balance gives the LPs exactly the hurdle IRR. The fee and waterfall model in the free workbooks for this book runs the same tiers for your own fund's terms. Once the pref is paid, the next tier is the catch-up, worked through in how the GP catch-up is solved.
Almost always on contributed capital, from the date each contribution is made. In the worked case calculating it on the full 100 commitment from the first close would require 100.37 in year 6 instead of 90.05, overstating what LPs are owed by 10.32.
A compounding pref accrues the hurdle on unpaid pref as well as on unreturned capital; a simple pref accrues only on capital outstanding. In the worked case the 8 per cent compounding pref is 40.05 by year 6 and the simple one 32.80, a gap of 7.25 on 100 of contributions.
They stop the accrual on the amount returned from the date it is paid. Moving the same 50 distribution from year 4 to year 2 cuts the pref owed in year 6 from 40.05 to 30.35; moving it to year 6 raises it to 48.37. Early distributions are worth more against the hurdle than late ones.
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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