When using a hurdle rate for carried interest, do you calculate carried interest on the entire increase in value, or only the increase in value past the hurdle rate?
eg.
Company in PE Fund goes from 50m to 100m. Hurdle rate is 25%, carried interest 20%.
Should carried interest be 10m (100-50 * 0.2) or should it be 7.5 (hurdle achieved at 62.5, so 100-62.5 * 0.2)
My intuition tells me it should be the second scenario, because if it was the first then the LP would actually lose money if the investment went from just under the hurdle to just over the hurdle.
It depends on whether the hurdle rate is a soft hurdle rate (carried interest is paid on all returns once the returns exceed the hurdle rate) or a hard hurdle rate (carried interest is paid only on returns that exceed the hurdle rate).
Ah yes I remember this now from Level I. I wish the level II notes had mentioned this. Thank you very much!
I have a question regarding soft hurdle rate:
In many exercices, where mgmt fees and incentive fees are calculated indenpendently, the soft hurdle rate is calculated as a gross profit (i.e. without taking mgmt fees into account). What if these were calculated net? Do I have to calculate the soft hurdle with the mgmt fees taken into account?