Demystifying Private Fund Terms: How to Explain Hurdle and Catch‑Up in English with Confidence

Concept clarity and purpose: What are hurdle and catch-up, and why do they exist?

In private funds, such as private equity and private credit, the legal document that sets the rules for paying out money is the Limited Partnership Agreement (LPA). Inside the LPA, the “waterfall” describes the order in which cash flows go to investors (Limited Partners, or LPs) and to the fund manager (the General Partner, or GP). Two critical pieces inside that waterfall are the hurdle rate and the catch-up. If you can explain hurdle and catch-up in English clearly, you will help colleagues and clients understand how performance pay works and why incentives are arranged in a specific way.

The hurdle rate is a minimum return that LPs must receive before the GP shares meaningfully in the profits through carried interest. Think of it as a “first promise” to the LPs: the fund must clear a certain annualized percentage return (for example, 8% per year) before carry is paid. The hurdle helps protect LPs from paying carry on mediocre outcomes and aligns the manager with the goal of delivering strong performance. Without a hurdle, the GP could earn carry even when the fund only slightly exceeds the capital invested, which many LPs consider unfair or misaligned.

The catch-up is the mechanism that allows the GP to “catch up” to their agreed share of profits once the hurdle has been achieved. If the fund does well and LPs have already received their contributions back plus the hurdle return, the catch-up phase speeds up the GP’s share until the intended longer-term profit split is reached (for example, 80% to LPs and 20% to the GP). The catch-up is not always present and does not always apply at the same speed; its style and rate are negotiated. But the idea is constant: once LPs are made whole and the hurdle is met, the GP is paid rapidly or proportionally so that the final distribution of profits matches the agreed economics.

Economically, these tools serve multiple purposes:

• They align incentives: The GP earns carry only after delivering a baseline return to LPs.
• They signal quality and market standard: Many institutional investors expect a hurdle to be present and clearly defined.
• They balance risk and reward across time: Early wins, losses, and fees affect whether and when the GP reaches the catch-up and starts earning carry.

Because of these roles, the precise definitions in the LPA matter. You will often see details about whether the hurdle compounds, whether it is calculated net of fees and expenses, and how unreturned capital or losses affect the catch-up. Clarity here is key to accurate modeling and to explaining the economics to different audiences.

Structures and variants: European vs American waterfalls, and catch-up styles

In practice, waterfalls come in two common structures that change when the GP can receive carry: European (whole-of-fund) and American (deal-by-deal).

• European, or whole-of-fund, waterfall means the GP typically does not receive carry until the fund as a whole has returned all contributed capital (and often fees and expenses) to LPs and delivered the hurdle. The GP’s carry is therefore back-loaded, and early strong exits do not immediately trigger carry if other parts of the portfolio are still underwater. This structure is favored by many LPs because it reduces the risk that the GP takes carry early, only to face losses later. It often leads to fewer issues with clawback—the requirement for the GP to return previously paid carry if later results destroy the fund’s overall performance.

• American, or deal-by-deal, waterfall allows the GP to receive carry after each profitable deal, once that deal alone has covered its share of capital and hurdle. Because the GP can earn carry earlier, this structure is more favorable to managers. However, it commonly requires protections for LPs, such as escrows, reserves, or interim clawback arrangements, to prevent over-distribution to the GP in the early years. While deal-by-deal can reward early success and improve GP cash flow, it can create more complex reconciliation if later deals lose money.

Within these waterfalls, the catch-up can be structured in three common styles:

• Full catch-up: Once LPs have received (1) their contributed capital back and (2) the hurdle return, 100% of subsequent distributions temporarily go to the GP until the GP’s share of total profits equals the agreed carry percentage. After that, profits split at the long-term sharing ratio (often 80/20). Full catch-up is the most GP-friendly because it accelerates the GP’s carry quickly after the hurdle is satisfied.

• Partial or proportional catch-up: After the hurdle is met, distributions are split so that the GP receives less than 100%, but more than the final sharing ratio, until the GP “catches up” to the target carry percentage. For example, distributions might be split 50% to the GP and 50% to LPs during the catch-up phase, before settling into the 80/20 split. This is a middle-ground design, moderating the speed of GP catch-up.

• No catch-up: There is no accelerated phase. After the hurdle is met, all additional profits are simply split at the final long-term ratio (e.g., 80/20). This is more protective of LPs because it prevents a sudden jump in GP distributions, but it is less common in traditional private equity funds.

Two technical nuances affect both hurdle and catch-up:

• Netting and fees: The hurdle is often calculated on an LP’s net invested capital, net of management fees and fund expenses, but the exact definition varies. Some LPAs set the hurdle against unreturned capital including fees; others separate fee treatment. These details can materially change when the hurdle is considered satisfied.

• Compounding: Hurdles are typically stated as annual percentages (e.g., 8%) and may compound annually. Whether the hurdle is compounded and how the compounding date is defined (e.g., from each drawdown date or from a weighted average) impacts the size of the LPs’ preferred return before the catch-up starts.

Numerical walkthroughs: Step-by-step payout sequences

To build confidence, it helps to walk through realistic payouts step-by-step, first in a European waterfall with a full catch-up, and later in an American waterfall with a partial catch-up. The aim is not to memorize numbers, but to understand the sequence of who gets paid and why.

European waterfall with full catch-up:

• Sequence logic: In this structure, the fund must satisfy the entire pool’s obligations before the GP earns carry. The order usually moves through capital return, preferred return (the hurdle), catch-up, and then long-term split.

• Step 1: Return of capital. All LP contributed capital is returned first, typically including fees and expenses depending on the LPA’s definition of “unreturned capital.” Until this amount is brought down to zero, the GP receives no carry.

• Step 2: Preferred return to LPs. After capital is returned, the LPs receive the cumulative hurdle amount—often a compounded annual rate. Only when the LPs have reached that preferred return is the hurdle considered “cleared.”

• Step 3: GP catch-up at 100%. With full catch-up, the next distributions go entirely to the GP until the GP’s share of cumulative profits matches the agreed carry percentage. This is the fast lane for the GP to reach 20% of the total profits (using a typical 80/20 example).

• Step 4: Residual split. After the GP has caught up, additional profits split according to the final ratio, such as 80% to LPs and 20% to the GP.

This sequence ensures LPs are made whole at the fund level and receive their time value of money through the hurdle before the GP accelerates into carry. Because it is whole-of-fund, losses in later deals can stop the GP from ever reaching Step 3, even if early exits were strong, which is why LPs often prefer this method.

American waterfall with partial catch-up:

• Sequence logic: Each deal is considered somewhat independently for carry purposes. After a successful exit, part of the profit may flow to the GP sooner, provided that deal’s share of capital and hurdle is covered. Protections such as escrow are common to prevent permanent overpayment if later deals lose money.

• Step 1: Deal-level capital return. From the exit proceeds of a particular investment, return the capital that funded that deal to the LPs.

• Step 2: Deal-level preferred return. Pay the hurdle associated with that deal’s capital. Depending on the LPA, the hurdle may be calculated per deal with compounding from the draw date. The aim is to ensure the LPs receive their time value of money for that deal before carry flows.

• Step 3: Partial catch-up. Rather than giving 100% of the next dollars to the GP, a proportional catch-up applies. For example, the LPA might state a 50/50 split until the GP’s cumulative share reaches the intended carry percentage for that deal. This slows the GP’s acceleration but still rewards performance earlier than a European waterfall.

• Step 4: Residual split. After the catch-up threshold is achieved, further profits are shared at the standard 80/20.

Because carry is paid earlier in an American structure, escrow or reserve accounts are often set up. If later exits underperform, the GP may need to return some carry, and the escrow helps manage that risk without immediate cash clawback from the GP’s partners.

What changes if fees, losses, or protections shift:

• Fees and expenses: If the LPA defines the hurdle on net invested capital after fees, the hurdle is harder to clear, delaying catch-up. If fees are not netted for hurdle purposes, the GP may reach catch-up sooner. The exact definitions significantly affect payout timing.

• Losses and write-downs: In a European waterfall, portfolio losses delay or eliminate catch-up until the whole fund recovers. In an American waterfall, losses in later deals can require clawback or trigger escrow releases back to LPs.

• Escrow and clawback: With deal-by-deal carry, a portion of the GP’s carry may be withheld in escrow to protect LPs if the overall fund later falls short. A clawback provision ensures the GP returns carry if, at fund termination, the GP has received more than the agreed share of final profits.

Plain-English drafting: Reusable sentences, micro-glossary, and checklist

Clear language builds trust. Here are practical sentence templates you can adapt for different audiences, all designed to help you explain hurdle and catch-up in English with confidence.

Templates for LPs (investors):

• “Our LPA sets an 8% annual hurdle rate, compounded, which means we will first return your capital and deliver an 8% preferred return before the GP receives carried interest.”
• “After the hurdle is satisfied, we operate a full catch-up: the GP receives 100% of the next distributions until the GP’s share equals 20% of total profits, and then profits are split 80/20 going forward.”
• “In a European waterfall, carry is calculated only after the entire fund has returned capital and the hurdle, reducing the risk of early overpayment of carry.”
• “For deal-by-deal carry, we maintain an escrow and a clawback provision to protect you if later deals underperform.”

Templates for internal teams (finance, IR, legal):

• “Please model the hurdle on net invested capital including management fees as defined in Section X; compounding is annual from each draw date.”
• “Switch the catch-up from full to 50/50 proportional in the sensitivity case and show the impact on GP carry timing.”
• “Under the American waterfall scenario, allocate escrow equal to 30% of interim carry, with annual true-ups against fund-level performance.”
• “Confirm the loss netting provision so that deal losses reduce the base before any carry is paid on subsequent exits.”

Templates for non-specialist stakeholders (board members, corporate partners):

• “The hurdle is a minimum return for investors; until we meet it, the manager does not receive performance pay.”
• “The catch-up is a brief period after the hurdle when the manager’s share increases so that the final split matches the agreed 80/20.”
• “A European waterfall waits for whole-fund results before paying carry; a deal-by-deal waterfall can pay carry after each successful deal, but it uses escrow to protect investors.”
• “In short, we explain hurdle and catch-up in English by saying: first, investors get their money back and a minimum return; next, the manager accelerates to reach their share; finally, profits split normally.”

Micro-glossary:

• Hurdle (preferred return): The minimum annualized return LPs must receive before the GP can earn carry.
• Catch-up: The phase after the hurdle where the GP receives an accelerated or proportional share of distributions until reaching the agreed profit split.
• Carried interest (carry): The GP’s share of profits after the hurdle and catch-up, often 20%.
• Waterfall: The order and rules that govern how money is distributed between LPs and the GP.
• European (whole-of-fund) waterfall: No carry until the fund overall returns capital and the hurdle.
• American (deal-by-deal) waterfall: Carry can be paid after each profitable deal, subject to protections like escrow.
• Escrow/Clawback: Mechanisms to hold back or recover carry if later results reduce overall profits.
• Netting: How fees, expenses, and losses are accounted for when calculating the hurdle and carry.
• Compounding: The method of growing the hurdle return over time based on an annual rate.

Accuracy and tone checklist:

• Define terms before using them, and keep definitions consistent with the LPA.
• State whether the hurdle is compounded and whether it is calculated net of fees and expenses.
• Specify the waterfall type (European or American) and the catch-up style (full, partial, or none).
• Mention any investor protections: escrow, clawback, or loss netting.
• Use neutral, professional language; avoid marketing spin when explaining economics.
• Where possible, align wording with the exact LPA sections to avoid ambiguity.

Bringing it all together: When you explain hurdle and catch-up in English, start with the purpose—protecting LPs and aligning incentives—then name the structure—European or American—and finally describe the catch-up style and any protections. Keep the sequence clear: return of capital, hurdle, catch-up, and residual split. Emphasize how fees, netting, and compounding affect timing. If you maintain this structure in your explanations, you will communicate precisely, reduce misunderstandings, and build credibility with both financial and non-financial audiences.