Skip to main content
← Back to A Definitions

Adjusted gross hurdle rate

What Is Adjusted Gross Hurdle Rate?

The Adjusted Gross Hurdle Rate is a conceptual modification of the standard hurdle rate in financial agreements, particularly within private equity and other alternative investments. While a traditional hurdle rate specifies a minimum rate of return that a fund must achieve before the general partner (GP) is eligible to receive carried interest, an "adjusted gross" version implies that certain predefined expenses or factors are excluded from the performance calculation before determining if the hurdle has been met. This aims to provide a more direct alignment between the fund manager's performance in generating investment returns and their incentive compensation, by isolating the investment-level performance from broader fund-level costs or specific adjustments agreed upon by limited partners (LPs). This concept falls under the broader category of investment strategy and fund structuring within finance.

The term "adjusted gross hurdle rate" emphasizes a nuanced approach to performance hurdles. Unlike a "net" hurdle rate, which typically accounts for all management fees and fund expenses before the hurdle is applied, an adjusted gross hurdle rate seeks to modify the gross performance figure before comparison to the hurdle. This adjustment aims to refine the metric that triggers performance compensation, making it more reflective of the underlying asset performance rather than overall fund operational costs. The Securities and Exchange Commission (SEC) has, in some contexts, highlighted the importance of clear disclosure regarding the calculation of gross versus net returns, indicating a regulatory focus on transparency in how these figures are presented and used for compensation.11

History and Origin

The concept of a hurdle rate itself gained prominence with the growth of private equity and hedge funds, serving as a critical mechanism to align the interests of fund managers (GPs) and investors (LPs). Initially, hurdle rates were typically set as a simple preferred return that investors had to receive on their capital commitment before the GP could participate in profits. Most private equity funds today include a hurdle rate, with a common threshold being 8%.10

As the private funds industry matured, and fund structures became more complex, discussions arose regarding the precise calculation of returns against these hurdles. The distinction between "gross" and "net" performance became a focal point, particularly concerning the impact of fees and expenses on investor returns versus manager compensation. Industry bodies like the Institutional Limited Partners Association (ILPA) have published principles to foster transparency and alignment of interests between GPs and LPs.9 The ILPA Principles, first published in 2009 and updated in subsequent versions, address aspects such as the calculation of carried interest based on net profits, after factoring in fund-level expenses.8 While the specific term "Adjusted Gross Hurdle Rate" might not have a single definitive historical origin point or regulatory mandate, it represents an evolution in structuring fund agreements to clarify which costs are excluded or added back to the gross performance before the hurdle is assessed. This reflects a continuous effort to refine the mechanics of the distribution waterfall to ensure fairness and clarity for all parties involved in a fund. For instance, recent SEC rules, although later vacated, aimed to provide investors with standardized quarterly statements detailing fund performance, fees, and expenses.6, 7

Key Takeaways

  • The Adjusted Gross Hurdle Rate modifies the raw investment performance by excluding certain pre-defined expenses or factors before comparing it against the hurdle, which is the minimum return required for a fund manager to earn performance fees.
  • This rate is primarily relevant in private equity and other alternative investment structures, influencing how carried interest is calculated and distributed.
  • It aims to provide a clearer view of the underlying investment's success, distinct from the broader fund expenses or administrative costs.
  • The application of an Adjusted Gross Hurdle Rate is typically detailed within the fund's governing documents, such as the Limited Partnership Agreement (LPA), reflecting specific agreements between general partners and limited partners.
  • Understanding this adjustment is crucial for limited partners to accurately assess the effective hurdle rate their capital must clear before managers receive incentive compensation.

Formula and Calculation

The Adjusted Gross Hurdle Rate itself is not a standalone formula but rather a conceptual application within the broader distribution waterfall of a fund. It dictates how the "gross" performance metric is adjusted before being compared to the contractual hurdle rate for the purpose of calculating carried interest.

While the exact "adjustment" can vary based on the fund's Limited Partnership Agreement (LPA), it generally involves starting with the gross return of the investment and then either adding back or subtracting certain specific items before applying the hurdle.

A conceptual representation of how it influences the calculation might look like:

Adjusted Gross Return = Gross Investment Return ± Specific Adjustments (e.g., exclude certain deal-specific costs, add back specific reimbursements)

If Adjusted Gross Return > Hurdle Rate, then Carried Interest is triggered.

Here, the "Specific Adjustments" are the key differentiator for an "adjusted gross" hurdle rate. These adjustments might be defined to:

  • Exclude certain non-recurring or deal-specific expenses: For instance, certain legal fees, financing costs, or broken deal expenses that are not considered part of the ongoing operational costs that would typically be covered by management fees or traditional fund expenses.
  • Reclassify certain income or expenses: Ensuring that the gross performance calculation accurately reflects the investment-level profitability before general fund-level overlays.

This adjusted figure is then compared to the hurdle rate, which is commonly expressed as a percentage. The outcome determines whether the general partner is eligible for their share of the profits. The internal rate of return (IRR) is often the metric used to measure performance against the hurdle rate.
5

Interpreting the Adjusted Gross Hurdle Rate

Interpreting the Adjusted Gross Hurdle Rate requires a careful review of the fund's governing documents, such as the Limited Partnership Agreement. This rate indicates a specific methodology for calculating the performance threshold that must be met before a general partner receives carried interest. Unlike a simple "gross hurdle rate," which applies to the raw return of an investment before any fees or fund-level costs, the "adjusted gross" variant introduces specific modifications to this gross figure.

The primary interpretation is that the fund's limited partners have agreed to allow the general partner to exclude or reallocate certain types of expenses when determining if the performance hurdle has been achieved. This can be viewed as an attempt to focus the hurdle on the core investment performance rather than on broader fund operational costs or idiosyncratic deal expenses that might otherwise depress the return below the hurdle. For example, if an investment generates a 15% gross return, but the fund agreement specifies that certain transactional costs (which might normally be deducted from gross returns to arrive at a "net" figure) are adjusted out for hurdle calculation purposes, then the 15% might be the figure used to compare against the hurdle.

For limited partners, understanding this adjustment is critical for realistic expectations regarding when carried interest payments will commence. It directly impacts the effective preferred return that investors receive before sharing profits with the fund manager.

Hypothetical Example

Consider a hypothetical private equity fund, Diversified Ventures I, with a hurdle rate of 8% annually. The fund's Limited Partnership Agreement (LPA) specifies an "Adjusted Gross Hurdle Rate" clause. This clause states that for the purpose of calculating performance against the hurdle, certain one-time, deal-specific advisory fees, which are not considered recurring management fees, will be excluded from the gross return calculation.

Scenario:
Diversified Ventures I invests $100 million in a company. After five years, the investment is sold for $180 million.

  • Gross Proceeds: $180 million
  • Initial Investment: $100 million
  • Total Gross Profit: $180 million - $100 million = $80 million

During the five-year holding period, the investment incurred $2 million in deal-specific advisory fees for the acquisition and subsequent strategic restructuring. These fees were paid by the fund.

Traditional Gross Return Calculation (without adjustment for hurdle comparison):
The Gross Internal Rate of Return (IRR) would be calculated based on the cash flows related to the investment, generally before all fund expenses. If these advisory fees were considered "gross" deductions, the gross profit for hurdle comparison might be $78 million.

Adjusted Gross Return for Hurdle Calculation:
According to Diversified Ventures I's LPA, these $2 million in deal-specific advisory fees are excluded when calculating the gross performance specifically for hurdle comparison. This means the performance for hurdle purposes is assessed as if these fees did not reduce the initial investment's effective return.

Therefore, for the purpose of assessing the hurdle:

  • Adjusted Gross Profit for Hurdle: $80 million (as if the $2 million was not deducted from the gross performance that is compared against the hurdle).
  • The fund's internal rate of return would then be calculated based on the $80 million profit. If this calculated IRR exceeds the 8% hurdle rate, the general partner becomes eligible for their carried interest.

This adjustment means that even though the fund incurred these costs, the general partner is evaluated against the hurdle based on a higher "adjusted gross" profit figure, incentivizing them to focus on the core investment's appreciation.

Practical Applications

The Adjusted Gross Hurdle Rate is most commonly found in the legal documentation governing private equity funds, venture capital funds, and other alternative investment vehicles. Its practical application lies primarily in determining the point at which the general partner (GP) begins to earn carried interest, their share of the fund's profits.

  1. Private Equity Fund Structuring: In the intricate world of private equity fund agreements, specifically the Limited Partnership Agreement (LPA), the Adjusted Gross Hurdle Rate can be negotiated between limited partners and general partners. It refines the distribution waterfall mechanism, ensuring that the GP's incentive compensation is tied to a pre-agreed measure of investment performance that may exclude specific, non-recurring, or deal-specific costs that aren't considered part of the core operational fund expenses.
  2. Incentive Alignment: By allowing for adjustments to the gross return figure before the hurdle is applied, the Adjusted Gross Hurdle Rate aims to better align incentives. It can encourage general partners to pursue certain investment strategy decisions, knowing that specific, agreed-upon transactional costs won't necessarily impede their ability to clear the hurdle and receive carried interest. This focus on "investment-level" gross performance, rather than an all-in net return, can be a point of negotiation.
  3. Transparency and Disclosure: The advent of regulations, such as the SEC's Private Fund Adviser rules (though recently vacated by a US Court of Appeals), has increasingly emphasized transparency in how fees, expenses, and performance are reported to investors. 4While the specific terminology "Adjusted Gross Hurdle Rate" might not be universally mandated, the underlying principle of clearly defining how performance is calculated against a hurdle, and what expenses are included or excluded, remains a key aspect of fund reporting. The SEC's push for detailed disclosures on fund performance, fees, and expenses has influenced how general partners present both gross and net returns to investors, promoting a clearer understanding of all components.
    34. Investor Due Diligence: For institutional investors, family offices, and other sophisticated limited partners conducting due diligence on a fund, understanding the nuances of the Adjusted Gross Hurdle Rate is crucial. It directly impacts the effective minimum return required from their capital commitment before profits are shared, influencing their overall expected returns.

Limitations and Criticisms

While the Adjusted Gross Hurdle Rate attempts to create a more precise link between investment performance and general partner compensation, it is not without limitations or potential criticisms.

  1. Complexity and Opacity: Introducing "adjustments" to gross returns can add layers of complexity to the distribution waterfall and make it more challenging for limited partners to fully grasp the true effective hurdle. If the adjustments are not clearly defined or are subject to discretion, it can lead to a lack of transparency regarding how carried interest is triggered. This contrasts with the broader industry push for simplified fee structures and increased clarity.
  2. Potential for Misalignment: Critics might argue that an Adjusted Gross Hurdle Rate, if not carefully structured, could inadvertently create a misalignment of interests. If too many expenses are "adjusted out" of the performance calculation for hurdle purposes, the general partner might be compensated for performance that does not fully reflect the real, all-in costs incurred by the fund. The Institutional Limited Partners Association (ILPA) Principles, for example, recommend that carried interest be calculated based on net profits, explicitly factoring in fund-level expenses, to ensure proper alignment.
    23. "Cherry-Picking" Concerns: If the adjustments are not rigidly defined, there could be a perceived risk that general partners might "cherry-pick" which costs to exclude from the hurdle calculation, potentially boosting the reported performance that clears the hurdle. This could lead to a scenario where investors are less insulated from certain costs than they might believe.
  3. Regulatory Scrutiny: The use of "gross" versus "net" performance figures, especially in marketing and reporting, has been an area of focus for regulators like the SEC. The SEC has provided guidance on presenting gross performance alongside net performance with equal prominence and comparable methodology. 1While the term "Adjusted Gross Hurdle Rate" is specific to fund mechanics rather than advertising, the underlying principle of how "gross" is defined and used for compensation purposes aligns with broader regulatory concerns about fair and transparent disclosure of returns to investors.

Adjusted Gross Hurdle Rate vs. Hurdle Rate

The primary distinction between an Adjusted Gross Hurdle Rate and a standard Hurdle Rate lies in how the fund's performance is calculated before it is compared against the hurdle. Both are minimum return thresholds that a private equity fund must achieve before its general partner (GP) can receive carried interest or other performance-based compensation.

FeatureAdjusted Gross Hurdle RateStandard Hurdle Rate
Performance MetricGross investment return, with specific, pre-defined expenses or factors excluded (added back for calculation purposes) from the gross figure.Typically, the gross investment return is used, without specific adjustments for certain expenses when measuring against the hurdle.
Expense TreatmentCertain agreed-upon expenses (e.g., specific deal-related fees, one-time costs) are disregarded for the purpose of meeting the hurdle.The gross return is considered before typical management fees and general fund expenses that would be netted out for the investor's actual return.
AimTo isolate the performance of the underlying asset from certain fund-level or deal-specific costs when determining GP eligibility for carried interest.To establish a baseline minimum return on investment before profit-sharing begins.
ComplexityGenerally more complex due to the need to define and track specific "adjustments."Simpler, as it applies directly to a more straightforward gross return calculation.

In essence, a standard hurdle rate looks at the gross return from the investment. An Adjusted Gross Hurdle Rate fine-tunes this "gross" figure by explicitly removing certain costs or elements, as stipulated in the fund's Limited Partnership Agreement, before testing whether the hurdle has been cleared. This means the general partner might be able to achieve their carried interest threshold more readily under an "adjusted gross" structure if the excluded costs are significant, as they are not factored into the hurdle calculation itself.

FAQs

What is the main purpose of an Adjusted Gross Hurdle Rate?

The main purpose is to define a specific way to calculate investment performance for the sole aim of determining when a fund manager, or general partner, becomes eligible for performance fees (carried interest). It "adjusts" the gross return by excluding certain agreed-upon expenses, focusing the hurdle on the underlying investment's profitability.

How does it differ from a "net" hurdle rate?

A "net" hurdle rate applies after all management fees and fund expenses have been deducted, reflecting the true return to the limited partners. An Adjusted Gross Hurdle Rate, conversely, makes specific adjustments to the gross return before comparing it to the hurdle, essentially allowing the gross figure to be assessed without the drag of certain pre-specified costs.

Is the Adjusted Gross Hurdle Rate common in all investment funds?

No, it is primarily found in alternative investment structures, such as private equity and venture capital funds. These funds often have complex distribution waterfall mechanisms that are negotiated between general partners and limited partners to align incentives and manage compensation.

How do investors find out if a fund uses an Adjusted Gross Hurdle Rate?

The details of how performance hurdles are calculated, including any "adjusted gross" provisions, are stipulated in the fund's Limited Partnership Agreement (LPA). Potential limited partners must conduct thorough due diligence and review these legal documents to understand the full terms of their investment.