Hurdle rate

A hurdle rate acts as a performance gateway for hedge fund managers. Before they can collect any performance-based compensation, the fund must first achieve a minimum level of returns for investors. This threshold can be set as a fixed annual percentage or tied to floating benchmarks that change over time.

Common benchmarks include SOFRSecured Overnight Financing Rate, a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. (Secured Overnight Financing Rate), Treasury rates, or major stock market indices like the MSCI World IndexA broad global equity index that measures the performance of large and mid-cap stocks across developed markets. or S&P 500. The choice of benchmark typically depends on the fund's investment strategy and what represents an appropriate baseline for comparison.

Hurdle rates come in two main varieties: fixed and variable. Fixed hurdle rates establish a specific annual percentage threshold that stays constant, typically ranging from 5% to 8%. Variable hurdle rates, on the other hand, move up and down based on external benchmarks like interest rates or market indices.

Variable hurdle rates can create unusual situations. For example, if a market benchmark falls 10% while the fund only loses 2%, the fund has technically outperformed its benchmark. However, this could create a negative hurdle rateA scenario where variable hurdle rates tied to benchmarks become negative when market benchmarks decline significantly. scenario. In such cases, the fund might carry forward this "credit" to future periods, though investors typically lose this benefit if they redeem their shares unless the fund agreement specifically states otherwise.

Once a fund crosses its hurdle rate, two different systems determine how performance fees are calculated. These are known as "hard" and "soft" hurdle structures.

In a hard hurdleA hurdle rate structure where performance fees are only paid on returns exceeding the hurdle threshold, never on the full appreciation. system, managers only collect their standard incentive rate on returns that exceed the hurdle threshold. They never receive their full target percentage on the fund's total appreciation because the first portion of returns goes entirely to investors.

Soft hurdleA hurdle rate structure that includes catch-up provisions allowing managers to receive their full performance fee percentage on all gains once the hurdle is exceeded. systems include a "catch-up" mechanism that allows managers to eventually receive their full target percentage on all fund gains, as if no hurdle existed in the first place.

When a fund uses a soft hurdle with catch-up provisionsPerformance fee mechanisms that allow fund managers to receive their full incentive compensation on all gains after crossing the hurdle rate threshold., managers can temporarily receive enhanced allocation percentages after crossing the hurdle threshold. This continues until they reach their intended compensation level based on total fund performance.

Here's how this works in practice: Imagine a $100 million fund with an 8% hurdle rate and a 20% performance fee. The first $8 million in gains would go entirely to investors to meet the hurdle. The next $2 million would go entirely to the manager as "catch-up" compensation. After that point, all additional gains would be split using the normal 80/20 allocation between investors and managers.

This structure ensures that once the fund achieves sufficient returns, the manager ultimately receives 20% of all gains, just as they would without any hurdle rate.

Some hurdle structures create what's known as a cliff effectA hurdle structure where performance fees apply to all gains once the hurdle is crossed, potentially creating counterintuitive investor outcomes.. In these arrangements, once the fund crosses the hurdle threshold, performance fees apply to all gains from the beginning of the period, not just the excess returns above the hurdle.

This can create counterintuitive outcomes for investors. Consider an investor with $1 million in a fund that has a 6% hurdle rate and a 20% performance fee applied to all gains once the hurdle is met. If the fund earns a 7% gross return, the investor pays 1.4% in performance fees (20% of 7%) and nets only 5.6%.

Surprisingly, this investor would have been better off if the fund had earned only 5.9% and stayed below the hurdle, avoiding performance fees entirely. The fund would need to achieve at least 7.5% gross returns before the investor would be better off than they would have been at exactly the 6% hurdle level.

Hurdle rates have become increasingly common in the hedge fund industry as institutional investors push for better alignment between manager pay and actual value creation. This trend has accelerated in the current higher interest rate environment, where investors want to ensure they're paying performance fees only for returns that exceed what they could earn in safer investments.

Industry surveys show growing institutional support for hurdle rates, particularly those tied to risk-free rates like Treasury yields. This approach ensures that managers are compensated for generating genuine alphaThe excess return generated by an investment strategy relative to a benchmark, representing the value added by active management.—returns above what investors could achieve through less risky alternatives—rather than benefiting from general market conditions or the current interest rate environment.