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.
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.
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.
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.
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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