How do net/gross PE returns and hurdle rates work?

I understand the 2/20 concept, but when a fund reports net returns, is that net of both the 2% management fee and 20% carry allocation? Or just the carry?

I also know a lot of funds have 8% hurdle rates -- is that on net or gross IRR and does that include the 2% management fee? If so, is the effective hurdle rate really 10% because you need to account for the management fee before you start to realize carry? Sorry if these are basic questions, I just realized that I don't know how the detailed mechanics actually work.

 
Most Helpful

These are good questions.

The best place to understand the answer is by looking at the distribution waterfall in an LPA.

It will say something like:

  • GP returns all the capital called
  • GP returns 8% pa for called capital
  • 100% catch up for GP until distributions equal 80/20 LP/GP
  • 80/20 LP/GP distributions thereafter

So to answer your question, capital can be called for investments, management fees and fund/partnership expenses. If a fund doesn’t recycle capital then typically you would expect 85% of capital to be called for investments and 15% for fees and fund related expenses.

In order for the GP to earn carry, the GP has to first return the full amount called and preferred return.

 

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