When the promote stops clearing: the hurdle as a binary threshold
Carried interest is not proportional to performance near the hurdle. It is a step function, and $2m of headroom is what stands between a promote and none.
A ten-investment fund clears its catch-up by exactly $2 million. Take the winners
from 1.8x to 1.7x — a 4.8 percent fall in proceeds — and the promote does not get
smaller. It stops.
Carried interest is usually described as though it were proportional: the fund does well, the
general partner earns more; the fund does less well, the general partner earns less. Over most of
the range that is true. Near the hurdle it is not true at all. The hurdle is a threshold, and a
threshold has one side and another side.
The fund
A $500M value-add fund makes ten investments of $50M each. Seven return 1.8x and three return
0.7x.
Outcome
Count
Invested
Multiple
Proceeds
Winners
7
$350M
1.8x
$630M
Losers
3
$150M
0.7x
$105M
Fund
10
$500M
1.47x
$735M
Total profit is $235M. Run it through the waterfall — capital back, preferred return,
catch-up — and the catch-up clears by $2 million. The general partner earns
its full promote, with $2M to spare on a $500M fund. Four-tenths of one percent of committed
capital.
Now move the winners
Nothing about the fund changes except the exit multiple on the seven investments that worked.
Winners at
Winner proceeds
Loser proceeds
Total
Profit
Fund multiple
1.9x
$665.0M
$105M
$770.0M
$270.0M
1.54x
1.8x
$630.0M
$105M
$735.0M
$235.0M
1.47x
1.75x
$612.5M
$105M
$717.5M
$217.5M
1.44x
1.7x
$595.0M
$105M
$700.0M
$200.0M
1.40x
1.6x
$560.0M
$105M
$665.0M
$165.0M
1.33x
At 1.7x the catch-up no longer clears. Compare the two rows:
Measure
Change from 1.8x to 1.7x
Proceeds
−4.8%
Profit
−14.9%
Fund multiple
1.47x to 1.40x
General partner's promote
−100%
A five percent move in exit values, on seven assets out of ten, in a fund still
returning 1.4x. In any performance discussion this is a good fund with a slightly worse year. In
the waterfall it is the difference between a full promote and none.
Why the leverage is this violent
Three effects compound at the hurdle.
Profit is geared to proceeds
Capital is a fixed subtraction. A 4.8 percent fall in proceeds is a 14.9 percent fall
in profit, because the $500M of capital comes out first and does not shrink with performance. On a
1.4x fund, every percentage point off proceeds costs roughly three points of profit.
The preferred return does not shrink either
The preferred return is calculated on capital and time, not on performance. It is the same
number in a good year and a bad one. So the whole of the reduction in profit lands on the tiers
below it — which is where the general partner's economics are.
The catch-up is all or nothing
The catch-up tier either has enough left in it to clear or it does not. There is no partial
state in which the general partner receives a proportionally smaller catch-up. Below the
threshold, the general partner's share of profit is zero and the limited partners take
everything.
What to do with this
For a general partner: know the headroom. Not the fund's projected multiple, but the distance in
dollars between projected proceeds and the point at which the catch-up stops clearing. On the fund
above that distance is $2M against $735M of proceeds — and it should be on the same page as
the projection, because it is the number that determines whether the promote exists.
For a limited partner underwriting a manager's track record: a fund that just cleared its hurdle
and a fund that just missed it look almost identical on gross performance and completely different
on net. Ask which side of the threshold each prior fund landed on, and by how much. A manager
whose promotes have all cleared by a hair has been lucky as well as good, and the two are worth
telling apart.
For anyone modelling it: derive each tier from the one above rather than asserting the residual.
The whole point of the sheet is to be able to move one exit multiple and watch the promote
disappear — which a model with the residual typed in will never show you.
The workbooks behind this article
Every figure above is a live formula in the companion files for
Private Equity Real Estate. Change one input and the rest of the sheet answers.
They are free, and they need no account and no email address.
Should corporate debt be fixed or floating?78.1818 per cent of gross debt fixed, and a net floating exposure after cash of -608,000.00 — the proportion, not the instrument.
Does an undrawn revolver count as liquidity?67.4567 per cent of the headroom, and it leaves at a fall in annual revenue of 8.4127 per cent — not the 13.3333 per cent the board deck implies.
Does supply chain finance count as debt?66,049,315 released, and leverage of 2.7622× or 3.1362× depending on which balance the test is asked of — the second is a breach at today's EBITDA.
How do you set a minimum cash balance?Three components, 124,596,281 in total — and the double count that turns a margin of 27,403,719 into an apparent shortfall of -3,988,281.
Is a 2/10 net 60 discount worth taking?An annualised 14.8980 per cent against a revolver at 4.50 per cent — worth 5,471,890 a year, and 0.3132 turns of reported leverage.
At what wealth does a family office pay?A five-person office costs the same $2,442,000 at $100m as at $2bn. Against a tiered multi-family schedule the two curves cross exactly once.
Does the fulcrum move with enterprise value?A worked capital structure at three enterprise values. The break migrates from the first lien to the subordinated notes without a single document changing.
How many companies does a reserve pool defend?Holding pro rata to the Series D costs $14.76m per company. A $40m reserve defends 2.71 of forty — and 61 per cent of the cost is the last round.
How much room a 1.15x downside actually leaves79 basis points of margin. The leverage covenant fails first, five basis points before the coverage covenant the chapter reports on, and 4.6 per cent of EBITDA is the whole cushion.
How the GP catch-up is actually solvedMost write-ups state the catch-up formula then hardcode the answer. Set it as a solve and it moves on its own when the carry rate does.
Six ways to state the same fund's return7.12 per cent, 18.04 per cent, or 1.323 times the public market — one fund, one set of flows. The eleven-point gap is the valuation, and it is not cash.
The IRR at which a closed-ended fund merely tiesA drawdown fund advertising 13.25 per cent ties an evergreen netting 8.64. On committed rather than called capital, 78.7 per cent of the edge vanishes.
The month a remediation trigger has to be armed byMonth 8, on a one-year window and a 14-week hiring lead time. The date is 12W − L/4.33 and holds for any portfolio size — the book only changes the euros.
Two routes to the same NAVFive findings in one quarter-end close, and not one of them was a modelling error. Every one was a control that did not exist.
What a CBAM certificate buffer costs to holdCarry and protection are both linear in the buffer, so the break-even probability is identical at 5 per cent and at 30 — and 2027 costs exactly twice 2026.
What a clawback actually collateralises24 million recovers 13.20 net of tax and 7.20 is escrowed. The rule is e ≥ 1 − t, and every euro won on the tax clause lands uncollateralised.
What a co-investment programme actually saves37 basis points, and a 22.8 per cent total-loss rate erases it. At the usual per-deal cap a single failure is 37 per cent of the annual cohort.
What a diligence exercise actually recoversEighteen basis points is only the part that reaches the yield. Three of the four instruments never do, and the exercise is worth thirty-one.
What a follow-on reserve is actually worth0.019 turns under plain dilution, 0.285 under pay-to-play. The optimum is a property of the shareholders’ agreement, not of the portfolio.
What a lease mark-to-market is actually worth5,788,000 becomes 807,365 once the over-market stream, the expiry dates and the cost of re-letting are priced — and nothing at all below a 43.7 per cent renewal rate.
What a minimum payment actually does£81.53 leaves the account and £20.46 reaches the debt. On minimums alone the set clears in 258 months and repays 1.78 times what was borrowed.
What a month of delay costs in an enforcement463,000 euros of present value a month. No single error about enforcement, and no pair of errors, moves the indifference point from 58.7 cents to the 72 on the table.
What a pro rata cheque actually costsDefending costs 1.25 times the initial cheque across two rounds, not more in each — and below a 521 exit the follow-on dollars come back worth less than they cost.
What a subscription line does to the IRR20 per cent becomes 38.41 on the same asset while the multiple falls. Two dollars of interest buys 18.4 points, and the longer the line runs the cheaper each point gets.
What one point of fees actually costsOne point on the annual charge turns 738,846 into 567,961 over forty years — 23 per cent of the pot, and 2.43 of wealth lost per 1 of fee.
Why a secondaries bid-ask gap has no zoneThe seller’s floor and the buyer’s ceiling are one formula at two rates. At equal required returns the zone is exactly zero — here it is 11.02 points apart.
Why refining a due diligence rubric makes it weakerThree of twelve managers carry a terminal flaw and the average approves all three. Splitting eight domains into sixteen makes it easier to hide, not harder.
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