Reimagining Hurdle Rates
Hurdle rates, one of the three key fund terms along with carried interest and management fees, are such a well-established entity in the private equity lexicon that changing them seems unthinkable. The overwhelming majority of buyout funds have hurdle rates of 8% IRR before the GP can claim any of the cash flows from the fund.
As it turns out, there is nothing magical about the 8% number that has become so common. Hurdle rates, when they were first contemplated in the 1980’s, were simply meant to provide LPs with the most basic sense of security as it relates to fund performance. Thus, the hurdle rate was set at 8% to match the return on a risk-free investment of a similar duration – the 10-year treasury yield. By current standards, this is an astronomical yield for treasury bonds – the 10-year bond yields have not gone above 3.5% in the past five years for example.
As more and more participants in the private equity community come to notice this anachronism, they have slowly begun proposing alternative ways of structuring incentives and we have worked with select clients to offer alternative structures for their LPs. Admittedly, we initially resisted such an alternate approach in a prior assignment but after pushing through on the thesis we came to understand that LPs may be willing to adjust the hurdle rate where there is a rationale business case for doing so; especially, if there a connection between the fund’s strategy, team and alignment of interest. Private Equity can take a leaf from the books of real estate funds and infrastructure funds, both of which started with the same 8% hurdle rate but have since moved on. In real estate, there is no standard hurdle rate used by all funds – each fund is bespoke, and LPs often allow for lower hurdle rates if the manager has performed well. In fact, managers often use their hurdle rates as a point of differentiation, wearing their low hurdle rate as a vote of confidence from their LPs. Infrastructure funds have also made hurdle rates more flexible by pegging them to the riskiness of the strategy – the more high-risk infrastructure strategies have a higher hurdle rate, while low-risk strategies have lower rates. Clearly, this makes intuitive sense and could be a model for private equity funds. “High-alpha” funds that target outperformance could be pegged at a higher hurdle rate, while defensive private equity funds that are targeting a lower risk-return profile might do with a lower hurdle rate.
Of course, there are other ways to structure hurdle rates to make them more aligned with the particular GP’s strategy. For example, many GPs are focused on returning a high multiple of capital, where IRR concerns play second fiddle to MOIC concerns. Such GPs could propose that they define their hurdle rate in terms of realized and unrealized MOIC at the time of exit – applying different weighting to each component if necessary. LPs could also propose certain milestones for the collection of carry, such as having a DPI hurdle in cash terms instead of an IRR hurdle.
There is a long way to go until alternate structures for hurdles are accepted and popularized by the private equity community. The current paradigm is very deeply set in the industry (even if seeing some signs of change) and GPs will often worry about proposing alternative structures lest they be misconstrued as showing a lack of conviction. Don’t. As I’ve always advised on these pages if you have a rationale business case then find the most strategic and constructive way to communicate your rationale and you might be surprised at the results
Sixpoint Partners, LLC, is a registered broker/dealer, member FINRA (http://www.finra.org) and SIPC (http://www.sipc.org). Sixpoint Partners Asia Limited is licensed by the Securities and Futures Commission (http://www.sfc.hk).
