In private equity investing, the hurdle rate, also known as the preferred return, plays a crucial role in determining the distribution of profits between the limited partners (investors) and the general partner (fund managers). This explainer will delve into what a hurdle rate is, its types, how it is determined, and its significance in the world of private equity.
What is a Hurdle Rate in Private Equity?
The hurdle rate, or preferred return, is the minimum rate of return that limited partners (LPs) expect to receive from their investments before the general partner (GP) can receive any carried interest (profit share). It acts as a benchmark to ensure that the GP only participates in the profits once LPs have achieved their expected returns.
Two types of preferred return hurdles
In private equity, there are two types of preferred return hurdles:
- Soft Hurdle Rate: In this type, the GP receives a share of the profits even if the returns fall short of the hurdle rate. However, the GP’s share is lower until the hurdle rate is met.
- Hard Hurdle Rate: Under a hard hurdle rate, the GP does not receive any carried interest until the hurdle rate is achieved. Once the hurdle rate is surpassed, the GP receives a share of the excess profits.
How Is a Hurdle Rate Determined?
The hurdle rate is typically negotiated and agreed upon during the formation of the private equity fund. It depends on various factors, such as the fund’s investment strategy, the risk profile of the investments, prevailing market conditions, and the expectations of the LPs and GPs involved.
How To Calculate The Private Equity Hurdle Rate
The hurdle rate is expressed as a percentage and is calculated based on the initial capital contributed by the LPs. For instance, if the hurdle rate is set at 8% and an LP has invested $100,000, they must receive a return of $8,000 (8% of $100,000) before the GP can start receiving carried interest.
How Hurdle Rates Work In Private Equity, an Example
Let’s say a private equity fund sets a hard hurdle rate of 10%. If the fund generates a return of 15% in a particular year, the LPs receive the first 10%, and the GP earns carried interest on the remaining 5%.
Hurdle rate in private equity: Why is it important?
The preferred return hurdle is crucial as it aligns the interests of the LPs and GPs. It ensures that the GPs prioritize generating strong returns for the LPs since they cannot benefit until the LPs have achieved their preferred return.
Hurdle Rate Example
For a better understanding, let’s consider an example: Suppose a private equity fund has a soft hurdle rate of 12%. If the fund generates a return of 15% in a given period, the LPs will receive their preferred return of 12%, and the GP will get carried interest on the remaining 3%.
Why does the preferred return hurdle exist?
The preferred return hurdle exists to protect the LPs’ interests and incentivize the GPs to generate higher returns. It ensures that the GPs are rewarded only when the LPs achieve their expected returns, making the investment structure fair and balanced.
Which Funds Have Preferred Return Hurdles?
Preferred return hurdles are common in private equity funds, especially those with a limited partnership structure. Venture capital funds, private equity real estate funds, and other private investment vehicles often adopt hurdle rates.
Hurdle Rate vs IRR
While the hurdle rate is the minimum return LPs expect before GPs receive carried interest, the Internal Rate of Return (IRR) measures the fund’s overall annualized return, factoring in the timing and size of cash flows. Both metrics are essential for evaluating fund performance.
How to Calculate Internal Rate of Return (IRR)
The IRR is calculated by finding the discount rate that sets the present value of all cash inflows equal to the present value of all cash outflows. It provides a single rate of return that represents the fund’s overall performance.
Which distribution happens first – preferred return or return of capital?
Preferred return and return of capital are different aspects of fund distributions. Preferred return refers to the minimum return LPs must receive before GPs participate in profits. Return of capital distributions, on the other hand, involve returning the LPs’ initial investments before any profit sharing.
which distribution happens first – preferred return or return of capital?
The distribution sequence depends on the specific terms of the fund’s legal agreements. In some cases, the preferred return is distributed before the return of capital, while in others, it may be the other way around.
Disadvantages of a Hurdle Rate
While the hurdle rate has its merits, it may also have drawbacks. For instance, if the hurdle rate is set too high, it could discourage GPs from taking on certain investments that could be profitable in the long term but may not meet the high return threshold in the short term. Additionally, it may create complexities in fund accounting and reporting.
