Well, imagine you and your friends want to start a lemonade stand business. You all decide to chip in some money to buy the ingredients and supplies, and then sell the lemonade to make a profit.
Now, let's say that you promised your friends that they will each get back their original investment plus some extra money as a reward for taking the risk. This extra money is called a return, and it's usually a percentage of the original investment.
But what if some of your friends want even more money than what you promised them? That's where an IRR hurdle comes in. It's like a special requirement that your friends have to meet in order to get that extra money.
For example, let's say that you promised your friends a 10% return on their investment. But you also set an IRR hurdle of 15%. This means that your friends will only get that extra money if the lemonade stand business makes a 15% return or more.
So if the business only makes a 10% return, your friends will still get their original investment back plus the 10% reward, but they won't get any extra money. But if the business makes a 15% return or more, they will get the extra money that you promised them.
In real estate syndication, an IRR hurdle works in a similar way. It's a way for investors to make sure they get a certain return on their investment before the sponsor (the person or company managing the investment) gets their share of the profits.
Here is a template to play around with IRR hurdles (including a GP catch-up provision). Doing this will make it more clear how these things work and returns are calculated throughout the hurdles.
Article found in Joint Venture.
