A hurdle rate in private equity (also referred to as a “preferred return” or “required rate of return”) is the minimum return that the fund must achieve for investors before the general partner (“GP”) or manager can share in the profits.
In most private equity funds, the general partner is incentivised to achieve strong results for the investors by participating in the return as part of their fee. The hurdle rate ensures that investors get a minimum specified return before the general partner is allowed to participate. The GP must exceed the hurdle rate to share in the profits.
Hurdle rates are cumulative and compounded annually. This means that returns to investors must exceed the hurdle rate for investment over its entire life before the GP can realise a share of the profits. The unrealised share of profits to the GP that may accumulate on an annual basis is referred to as “carried interest” or simply “carry”.
Although unique to each fund, hurdle rates are usually measured using either the Internal Rate of Return (IRR) or a multiple of the initial investment. The details differ among funds and are described in the fund’s offering documents. A hurdle rate of around 7-8% is typical of private equity agreements.
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A hurdle rate in private equity is a minimum return that investors must receive before the GP can share in the profits.
Hurdle rates vary and can be found in a private equity fund’s offering documents.
Hurdle rates are cumulative and compounded annually.
Hurdle rate in private equity: Why is it important?
Hurdle rates are important to both investors and general partners. For investors, a hurdle rate provides the general partner with an incentive to maximise the investor’s return. In addition, the hurdle guarantees that the investors will receive a minimum return before the GP can share in the profits.
For general partners, it means that they will be rewarded for good performance, provided they can exceed the hurdle rate.
Hurdle Rate vs IRR
Often confused, a hurdle rate is not the same as the IRR. A hurdle rate is a specified minimum return below which the general partner cannot share in the profits of the fund. The IRR is the actual rate of return earned by the fund, which may be above or below the hurdle rate.
Hurdle Rate FAQs
What is the soft and hard hurdle rate?
There are two ways to share profits when a hurdle rate is exceeded. A soft hurdle rate allows the general partner to share in all returns this far, whereas a hard hurdle rate allows the general partner to begin sharing from the hurdle rate.
As an example, assume a fund has an 8% hurdle rate and has achieved a 16% cumulative return. A soft hurdle rate would allow the general partner to share in the full 16% return, while a hard hurdle rate would allow the general partner to share only in the excess 8% over the hurdle rate.
Who sets the hurdle rate?
General partners set the hurdle rate with their offering documents.
Performance incentives are commonly built into private equity funds to align the general partner’s interests with those of the investors. The hurdle rate defines the level of returns investors must receive before these performance incentives kick in, thus providing a benchmark return for the general partners to exceed while providing investors with a minimum preferred return before sharing it with the GP.
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In business and for engineering economics in both industrial engineering and civil engineering practice, the minimum acceptable rate of return, often abbreviated MARR, or hurdle rate is the minimum rate of return on a project a manager or company is willing to accept before starting a project, given its risk and the ...
in private equity (also referred to as a “preferred return” or “required rate of return”) is the minimum return that the fund must achieve for investors before the general partner (“GP”) or manager can share in the profits.
A hurdle rate is the lowest rate of return a project or investment must achieve before a manager or investor deems it acceptable. It's important when companies or investors make important decisions like pursuing a specific project. Riskier projects generally have higher hurdle rates than those with less risk.
The minimum return to investors to be achieved before a carry is permitted. A hurdle rate of 10% means that the private equity fund needs to achieve a return of at least 10% per annum before the profits are shared according to the carried interest arrangement.
There are essentially two main types of waterfall structures that are used in real estate investments. The first is based on returning all capital to investors + an expected return (aka the “hurdle rate”); the second is based on a preferred rate of return (aka “the pref”) on a periodic basis.
Credit funds typically set hurdle rates below 8%, with the majority being between 5% and 7%. The majority of US venture funds do not have a hurdle rate, but they are much more common outside the US.
IRR is a metric that identifies to an investor the average annual compounded return they have realized from a real estate investment over time, expressed as a percentage. The preferred return is the first claim on free cash flow distributions.
The hurdle rate is the minimum rate of return on an investment that will offset its costs. The internal rate of return is the amount above the break-even point that an investment may earn. A favorable decision on a project can be expected only if the internal rate of return is equal to or above the hurdle rate.
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
There are typically two types of hurdle rates - "hard" and "soft". A hard hurdle means the manager only receives payment on the returns that surpass the hurdle rate. Conversely, a soft hurdle means that once the hurdle rate is met, the manager gets paid on all the returns, including those below the hurdle.
The difference lies in the return on and return of capital. The preferred return is a preference in the returns on capital, while a preferred equity position is one that receives a preference in the return of capital.
The formula for calculating hurdle rates involves adding the WACC and the risk premium. The risk premium accounts for the level of risk associated with the investment and reflects the additional return required to compensate for that risk.
A preferred return—simply called pref—describes the claim on profits given to preferred investors in a project. The preferred investors will be the first to receive returns up to a certain percentage, generally 8 to 10 percent.
Hurdle rate is a critical concept in waterfall calculations. It represents the minimum rate of return that must be achieved before GPs are entitled to carried interest.
A high-water mark is the highest peak in value that an investment fund or account has reached. This term is often used in the context of fund manager compensation, which is performance-based. The high-water mark ensures the manager does not get paid large sums for poor performance.
Preferred returns for an entire syndication can be calculated by multiplying the equity from the investor class by the preferred rate. For example, if $1 million is raised from investors to purchase a property, and the preferred rate is 6%, the annual preferred return would be $60,000.
Hurdle Use in its commonly accepted sense of a hurdle return, i.e., the lowest possible return which a particular investor will accept. However, also used specifically to describe a return which a GP has to at least equal before any carry is calculated or payable.
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