The market has seen a sharp increase in private equity firms removing the traditional 8 percent preferred rate of return – and consensus is this will only increase.
The share of PE firms that removed hurdle rates altogether doubled to 22.6 percent in 2019, from 11.9 percent in the previous year, a report from law firm MJ Hudson found. The number of funds with a hurdle of exactly 8 percent fell for the second consecutive year to 60 percent, from 71 percent in 2018 and 76 percent in 2017.
Private Equity International spoke with industry participants about potential knock-on effects of the vanishing hurdle rate.
Eamon Devlin, a partner at MJ Hudson, said hurdle rates coming down is an example of “the power struggle going on between LPs and GPs”, and some larger funds are “still winning the fight”.
Devlin expects the growth in funds with no hurdle to come from two places: large buyout managers with a reasonably good track record; and US venture funds moving into growth strategies.
Funds from large buyout shops that have no preferred hurdle include Hellman and Friedman’s ninth fund, which collected $16 billion in 2018. Advent International, which collected $13 billion for its eighth fund in 2016, is understood to have removed the internal rate of return-based hurdle and kept its multiple-based hurdle.
Jim Strang, head of EMEA at Hamilton Lane, expects GPs will continue to look at reducing hurdle rates as they are in a strong position to demand structures that are favourable to them.
“LPs’ ability to push back is reasonably limited. You can try; we do. But it is ultimately a supply-and-demand-driven dynamic,” he said.
GPs are particularly focused on hurdle rates as they begin to anticipate a downturn, which could lead to holding assets for longer to generate greater value, in turn negatively affecting IRRs.
“Generally you don’t try and push the fees up, you don’t try and push the carry up. You try and push the hurdles down,” he said. “If you think there’s going to be a wobble, one thing you may get caught up in is time. And the hurdle is driven by time.”
A London-based managing director, whose firm recently wrapped up fundraising, noted that reducing the hurdle rate could affect the behaviour of fund managers, including accelerating the sale of assets or betting on high-risk deals. To him, “dropping the hurdle rate is the last frontier of what GPs can ask for”.
Meanwhile, a managing partner of a European buyout shop said the firm “feels confident enough” not to remove the hurdle rate for its funds. Early this month the firm hit the hard-cap for its latest vehicle, which has a hurdle rate, PEI understands. “It’s a non-issue for us; we don’t need to remove it, and LPs appreciate it,” said the managing partner.
While beating the hurdle is an easy feat for top quartile US buyout funds, that’s not the case for everyone; bottom quartile funds missed the 8 percent mark by almost 2 percentage points, according to research from private equity software provider eFront, which analysed US buyout funds from 1991 to 2012.
One-size-fits-all hurdle is ‘inadequate’
Exceeding the hurdle is more challenging for venture funds, which historically have never had a hurdle rate. US venture capital funds analysed during the same period only managed to beat the hurdle with an 8.98 percent average pooled return. The top 25 percent of VC funds did not reach the hurdle in four instances during the period, while the lion’s share of the bottom 25 percent did not reach the 8 percent threshold.
The fact the hurdle rate is calculated as IRR – a time-sensitive metric – works in favour of buyout funds, while the use of credit lines could also help the manager reach the performance threshold. Macroeconomic and business conditions also play a role in a fund’s performance.
A one-size-fits-all hurdle rate calculated as an IRR, therefore, appears to be “inadequate”, and the method of calculation is long overdue a revamp, Tarek Chouman, chief executive of eFront, said in a statement accompanying the report. Most participants agree the diminishing hurdle rate calls for a re-assessment of the performance metric and a serious re-think of the level of alignment between the LP and GP.
Devlin noted the private equity world is looking at a performance metric that’s become increasingly useless because the numbers do not give out a good reading of performance.
“IRR is becoming increasingly less functional and I think that will be replaced in time,” he said.