It is one of the “holy trinity” of fund terms, alongside management fees and carried interest. And despite the fact it spurs a lot of discussion, the hurdle rate – or preferred return – has remained broadly unchanged since its introduction in the 1980s.
I wrote in this column last month that a hurdle rate is seen by many investors as a “nice-to-have” – rather than a “must-have” – fund term. Further evidence of this came to light last week: Hellman & Friedman IX, which is in market seeking $15 billion, has no preferred return hurdle within its fee structure. According to investment advisor Pavilion, any risk related to this is “sufficiently managed” by other ways in which the firm fosters alignment with investors (as well as its beefy investment track record).
The previous column prompted a number of responses – including some dismay at the fact that after 30 years there had been little innovation in this department. Here are some of the points that were raised:
The risk-free rate
The 8 percent number is nothing more than an accident of history. As Ray Maxwell, a veteran LP, points out in an article soon to be published on Private Equity International, the pref was set based on the “risk-free” rate of return available at the time of its conception. “The rate was deemed to be the yield on a gilt with similar maturity to the weighted average life of a private equity partnership, which was estimated to be around six to seven years and in the late 1980s that rate was around 8 percent. This figure has become a standard feature even though the yield on a 10-year gilt today is only 1.42 percent and equity returns today would struggle to exceed 8 percent.”
Looking at other asset classes within private markets is informative. I recently participated in a discussion – available as a podcast – with colleagues from real estate and infrastructure, and a placement agent with a view across the asset classes.
While real estate and infra both started with same 8 percent hurdle, they have moved in different directions. In real estate there is no standard; it is negotiated fund by fund and, as such, a low hurdle rate is viewed as vote of confidence by investors and worn like a badge of honour by a manager. In infrastructure, the private equity standard 8 percent still generally applies at the riskier value-add end of the spectrum, but elsewhere on the risk-return spectrum the hurdle drops a notch or is predicated on yield.
The disincentivisation of a lost cause
One of the imperfections of the hurdle rate as a means to promoting investor-manager alignment is the lost cause scenario: when underperformance means the hurdle becomes insurmountable and the incentive to generate outperformance is lessened for the GP. As placement agent Patricia Wilkinson says in the podcast: a GP will do its fiduciary duty regardless of incremental performance payments, because its track record is on the line. This can only be partly true; if incentivisation doesn’t matter, then the whole notion of carried interest is called into question.
Inventing a better mousetrap
Advent International is often held up as a prime example of one of the few firms that has been able to scrap its hurdle rate. Unlike the predecessors, its $13 billion eighth fund in 2016 did not have one. Often overlooked, however, is the fact the fund does have a high-watermark to meet, in terms of a multiple of invested capital for distributions and unrealised investments, before carry is paid. This was nudged up by investors as the IRR-based hurdle was ditched. If you are an investor that favours multiples over IRRs – as some do – then surely this must seem like a better mousetrap.
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