What is a Hurdle Rate in Private Equity?
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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Key Takeaways
- 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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Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. Private equity is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.
FAQs
It acts as a performance threshold that ensures limited partners (LPs) get a certain return on their investment before the general partners receive theirs. Hurdle rates in private equity typically range from 7% to 8% but can vary based on the fund's strategy and the agreement between LPs and GPs.
Is preferred return a hurdle rate? ›
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.
What is the typical preferred return in private equity? ›
Most private market funds set their hurdle rate or preferred return at around 8%, though this may vary depending on the fund's strategy. This means the fund manager must generate an annualized net return of at least 8% for investors before the manager can share in any of the fund's profits.
What is the DPI formula for private equity? ›
DPI: The distribution to paid-in capital (DPI) measures the ratio of cash distributions investors receive to the total capital invested in a private equity fund. It is calculated by dividing the total cash distributions by the total capital contributed by investors.
What is an example of a hurdle rate of return? ›
One of the managers responsible for the project estimated the risk premium associated with the project to be 4%. Based on the provided data, what is the minimum acceptable return, or hurdle rate, that the company should accept? Using the hurdle rate formula, the hurdle rate equals 5% + 4% = 9%.
What is the difference between IRR and hurdle rate? ›
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.
How does preferred return work in private equity? ›
Preferred Equity gets paid out before Common Equity and is priced at a certain percentage return, called a preferred return. That return can be paid current out of cash flow, accrue, and be paid upon a sale, or a combo of both.
What is the difference between preferred equity and preferred return? ›
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.
What is the difference between IRR and preferred return? ›
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.
What is an example of a hurdle rate in private equity? ›
Case Study: Hurdle Rate Application in a Private Equity Deal
In this example, if the fund generates a 12% return, the limited partners receive their 8% hurdle rate, and the remaining 4% is split between the general partner (20%) and the limited partners (80%).
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.
What is a good DPI? ›
What DPI Setting Should You Use? The ideal DPI setting varies based on the genre of game, personal preference, and even the resolution of the monitor in use. Speaking broadly, however, a DPI setting between 400 to 3600 will cover nearly all players.
What is the 2 20 rule in private equity? ›
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.
What is the difference between IRR and DPI? ›
In essence, while DPI provides a snapshot of the actual returns to investors, IRR offers a forecasted rate of return based on all expected cash flows. A high IRR projection might attract investors, but a strong DPI is crucial for demonstrating actual performance and investor satisfaction.
What is the hurdle rate in private equity waterfall? ›
A hurdle rate is the minimum rate of return a project or investment must achieve to be approved by an investor or manager.
What is an 8% hurdle rate? ›
Calculating Hurdle Rate
For example, if an investor's cost of capital is 5%, and the risk premium for a specific investment is 3%, the hurdle rate would be 5% plus 3% or 8%. In this case, the investment under consideration would have to offer a return of 8% or better in order to clear the hurdle rate.
What is the hurdle rate for Warren Buffett? ›
Warren Buffett will only buy stocks and businesses for Berkshire Hathaway if they meet his quality criteria.
What is the hurdle rate in a hedge fund? ›
A hurdle rate is the minimum rate of return that the hedge fund manager should generate before it is able to charge a performance fee. Hurdle rates are either a fixed or variable rate, often linked to a benchmark interest rate, such as Libor.
