Q&A: Adjusting the hurdle

In a protracted period of low interest rates some GPs are silently thinking a guaranteed 8 percent rate of return is outdated. Are they right?

Benson: The question is somewhat philosophical in nature, as different people have different views about what the hurdle rate is intended to achieve.  Some GPs say an eight percent hurdle is too arbitrary and that the rate should be dynamic, reflecting prevailing economic conditions, especially today when investment returns and interest rates are relatively low. Others view it as a benchmark of private equity’s status as an asset class that delivers consistent performance, that even in depressed markets they should be confident in their ability to generate the performance needed to hit that hurdle and be rewarded with carried interest. The reality is that opening up negotiations around this issue will likely open negotiations around other economic terms, and many GPs are not necessarily in a strong bargaining position right now.  So whilst some may think the 8 percent rate is outdated, I don’t believe they are actively seeking to change it.  

Nick Benson

So is the eight percent hurdle here to stay and that’s that?

Yes, for the foreseeable future, with one or two exceptions.  One variation that has been discussed, though has yet to be widely adopted in private equity fund terms, is some form of LIBOR linked variable hurdle rate. The logic of this is to provide linkage to the returns that an investor would otherwise be able to obtain on its cash in the prevailing markets. We have seen higher fixed rate hurdles on some emerging markets private equity funds which are denominated in high growth currencies. There are one or two existing funds I can think of that have a lower fixed rate hurdle (e.g. 7 percent), which is exceptional and a legacy of the sponsors’ historic fund terms rather than a recent development.  

Are there any related points of negotiations around the 8 percent hurdle mark? 

There has always been negotiation around precisely how the preferred return is calculated. For example some funds calculate the preferred return on every amount drawn down, regardless of what it is used for. Others carve out draw downs for short term bridging investments, which are repaid within a year with any bridging profits, are available to be re-drawn, and are therefore treated as short term borrowings by the fund to facilitate its long-term investments. 

Another negotiation point relates to the compounding of the preferred return. In most funds the 8 percent is compounded annually but in some you see a simple 8 percent per annum rate with no compounding, which effectively lowers the hurdle.  

The timing of the preferred return calculation is also relevant. Does it start from the date of draw down, or the date of completion of the investments?  If the latter, investors will be resistant to the idea that the GP could sit on the drawn down capital for a long period before utilisation without that period being factored into the preferred return calculation.  To the extent there has been movement in this area recently, it has been in the direction of ensuring the preferred return clock starts ticking at the point of drawdown, and stops only upon distribution.