Updated · Part of the CRE investment glossary
The main hurdle types
A waterfall pays tiers in order; each hurdle marks where one tier ends and the next, with a richer GP split, begins. The types sponsors and LPs negotiate most often:
- Return of capital: investors get their contributions back before any profit split. Often the first tier, sometimes paid after the pref.
- Preferred return: a percentage of contributed capital each year — simple or compounding, cumulative or not — paid before the GP shares in profits.
- IRR hurdle: the split changes once investors’ cash flows reach a target internal rate of return, for example 8%, then 12%, then 15%. It accounts for when each dollar was paid.
- Equity multiple hurdle: the split changes once total distributions reach a multiple of capital, for example 1.5x or 2.0x. It ignores time.
- Cash-on-cash hurdle: an annual yield test, used for operating cash flow rather than the sale.
- Combined hurdles: the agreement requires investors to reach both an IRR and a multiple — or the greater of the two amounts — before the promote steps up.
The formula: what investors must receive
For a single investment with all cash returned at the end of year n:
IRR hurdle met when distributions ≥ capital × (1 + IRR target)^n Multiple hurdle met when distributions ≥ capital × multiple target
- With interim distributions, the IRR test is solved on the dated cash flows — the hurdle balance grows at the target rate and is reduced by each distribution.
- An IRR hurdle behaves much like a compounding preferred return on unreturned capital.
- The multiple test counts every dollar distributed, whenever it was paid.
Worked example: the hold period decides which hurdle binds
Investors put in $1,000,000. The promote steps up after a 12% IRR hurdle or a 1.8x equity multiple hurdle. Assume all the cash comes back at the sale. A 1.8x multiple always needs $1,800,000. A 12% IRR needs $1,404,928 after three years, $1,762,342 after five and $2,210,681 after seven.
So on a short hold the multiple is the harder test, and on a long hold the IRR is. That is why agreements that use both — "the greater of a 12% IRR and a 1.8x multiple" — protect investors at both ends: a quick flip cannot trigger the promote on a small profit, and a slow deal cannot trigger it on a weak annual return.
| Hold | 12% IRR needs | 1.8x multiple needs | Binding hurdle |
|---|---|---|---|
| 3 years | $1,404,928 | $1,800,000 | Multiple |
| 5 years | $1,762,342 | $1,800,000 | Multiple |
| 7 years | $2,210,681 | $1,800,000 | IRR |
Details that change the answer
Two agreements can both say "12% IRR hurdle" and pay differently:
- Whose IRR: the investor class net of fees, or the deal before fees.
- Dates: annual periods (like Excel’s IRR) or the actual dates money moved (like XIRR). Dated cash flows give different results when contributions or distributions fall mid-year.
- Catch-up: whether the GP catches up after the pref or a hurdle, and how fast.
- Timing of the test: deal by deal (American) or after all capital in a fund is returned (European), and whether a clawback applies if an early promote is later unearned.
- Compounding and accrual for a pref: simple or compounding, cumulative or not, from which contribution date.
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.