Key Takeaways

  • Raising private equity hurdle rates from 8% to 12% risks leaving carried interest completely out of the money across normal market vintages.
  • The average 2021 private equity fund vintage tracks at roughly 10% net returns, well beneath a 12% preferred return threshold.
  • Carried interest serves as the primary control institutional LPs hold to govern GP behavior; stripping it away distorts manager incentives.
  • When carried interest goes underwater, GPs face perverse incentives to coast on management fees rather than drive difficult exits.

The Math That Breaks Carried Interest

Facing a tight fundraising environment, some fund managers have offered elevated hurdle rates of up to 12% to entice institutional investors. The pitch sounds attractive on paper: LPs lock in a higher guaranteed return before the general partner touches performance fees. But Adam Turtle, co-founder of placement advisory firm Rede Partners, argues this concession backfires directly on the investors demanding it.

Turtle looks at historical performance math. “My concern with a 12% hurdle, if you look at the average performance right now to say for example a 2021 fund, average, which means that's I guess what you should expect,” Turtle explains. “We all believe we'll, there's always that joke that 70% of people believe they're better than average, but the truth is 50% is the right number. It's 10%.”

If the median fund delivers 10% net, setting a hurdle at 12% guarantees that half of all managers generate zero performance fees. Turtle points out the arithmetic consequence: “So, if you do raise the hurdle to that sort of level, you will then have a lot of funds that are not in that carry situation.”

The Zombie Asset Risk

The private equity governance model rests on a single pillar: carried interest aligns GP decisions with LP returns. When that incentive evaporates, the GP's operational calculus shifts immediately toward capital preservation and fee collection.

Turtle warns that stripping carry out of reach creates unpredictable managerial behavior. “My concern with that is that ultimately the hurdle, the only real control or the most powerful control that LPs have is the incentivizing power of carried interest,” he states. “You do not want to be in a situation where your manager hasn't got the incentive of carried interest because at that point becomes a bit less clear exactly what they're incentivized to do. Is it just to hold on for the management fees?”

In down or sideways markets, an aggressive hurdle hurts LPs during the exact windows where GP effort matters most. Turtle notes, “When markets work against you, you also want to make sure that your managers have something to work for. Pretty quickly in down markets that will become carry will become out of the money and then LPs have a different problem on their hands.”

Once a fund cannot reach its hurdle, partners stop working nights to turn portfolio companies around. Senior dealmakers depart for newer funds with live carry programs. The fund drifts into an administrative holding pattern, collecting 1.5% to 2.0% in management fees while leaving LP capital stranded in illiquid holdings.

Why It Matters

Pushing hurdle rates to 12% signals that LPs are trading governance alignment for paper protections. In an extended liquidity drought where distributions lag and vintage returns compress toward historical medians, artificial hurdles create zombie funds managed purely for fee extraction. The 8% hurdle endured across multiple cycles because it keeps deal teams tethered to enterprise value creation when market headwinds hit.