Private equity funds could become riskier investments if there’s no longer a preferred rate of return, according to Eamon Devlin, a partner at asset management consultant group MJ Hudson. Devlin helped author the firm’s latest research on private equity and venture capital funds.
MJ Hudson found that 60 percent of funds surveyed have an 8 percent hurdle rate, according to the fifth edition of its Private Equity Fund Terms Research, which was published on July 1. The latest figure marks a 16 percent drop from 2017, when 76 percent of respondents carried 8 percent prefs. In 2018, 71 percent of funds held the 8 percent rate.
Hurdle rates are the minimum rate of returns on investments that a private equity fund must reach before a GP receives carried interest. Despite the drop, the 8 percent hurdle rate remains the industry standard.
The 8 percent preferred return rate is no longer “risk free” because of the decade of low interest rates following the 2007-2008 global financial crisis, the report said.
“A fund without a hurdle is a riskier investment for LPs. It’s less exposure for GPs and thus is a favorable move for GPs,” Devlin said. “Most LPs are very disappointed because it’s not a favorable change to the relationship. If your fund is 2x oversubscribed, then the LPs don’t have much negotiating power.”
According to the study, 86 percent of buyout funds have a hurdle rate of 8 percent. Researchers found that 23 percent of funds surveyed in the 2019 report have no hurdle at all, a notable increase from the 12 percent of funds in last year’s report, largely because more venture capital funds were included in the study.
“Some people believe if you have a hurdle then it makes venture capital managers too cautious for investment choice,” Devlin said. A hurdle rate is based on IRR. Not having an IRR arguably allows managers to be more patient with their investors.”
Less than two-thirds, or 58 percent, of buyout funds were surveyed for the study, but unlike the 2018 study, infrastructure, real estate and private debt funds were excluded from this year’s report.
The funds in the study raised close to $145 billion, according to the survey.
Hurdle rates are not expected to disappear any time soon, but the industry may see funds lower the rate or completely remove them, according to the study.
“If it’s not 8 percent, then the hurdle is normally 7, 6 or zero,” Devlin said.
Action Item: Check out the study here: https://bit.ly/2xoA5t7