Research By: Amisha Aggarwal
A hurdle rate is the minimum rate of return an investor or company expects to earn from an investment or project.
Investing with other investors in a pool of assets through a fund manager, who chooses and oversees a group of investments based on a predetermined plan, is known as fund investing. A portion of the investable funds (management fee) and a portion of the investment gains (incentive fee) are usually given to the manager.
Regardless of the performance of the investments, the fund manager gets paid the management fee. The percentage of assets under management (AUM), or the net asset value of the fund’s investments, is used to compute management fees for hedge funds. The management fee for private equity funds is determined by taking the percentage of committed capital rather than the invested capital. Usually, committed capital is “drawn down”—that is, invested—as securities are found and added to the portfolio, rather than being invested in its entirety at once. Typically, committed capital is depleted over a period of three to five years; however, the fund manager retains discretion over the exact timing of this process. Dry powder refers to committed capital that has not yet been depleted.
Performance fees, also known as incentive fees, represent a share of the profits generated by a fund’s investments. Typically, the partnership agreement outlines a hurdle rate (or preferred return) that must be achieved before any performance fees are payable. Hurdle rates can be categorized as either “hard” or “soft”. If a soft hurdle rate is met, performance fees are calculated as a percentage of the entire gain in each partner’s investment. In contrast, with a hard hurdle rate, performance fees are charged only on the gains that exceed the hurdle rate.
For example, consider a fund with a hurdle rate of 8% that has produced a return of 12% for the year. We will use a performance fee structure of 20% of gains. If the 8% is a soft hurdle rate, the performance fee will be 20% of the entire 12%, or 2.4%. If the 8% is a hard hurdle rate, the performance fee will be 20% of the gains above the hurdle rate (12% – 8% = 4%), which would be 0.8%.