Hurdle rates gradually creep downward, though 8 pct remains norm: study

Hurdle rates, the threshold a private equity fund must hit before a GP begins to collect carried interest, have gradually been falling, but 8 percent remains the industry norm, consultant MJ Hudson reports.

Nearly two-thirds (66 percent) of funds in the survey were PE, but respondents also included infrastructure, real estate, growth capital, venture capital and private debt funds.

Together, the funds targeted more than 154 billion euros ($179.2 billion) of capital in commitments, the terms-and-conditions survey, published this month, said.

MJ Hudson found that more than 15 percent of respondents reported having a hurdle rate of less than 8 percent, more than twice the 6.6 percent of last year.

Still, more than 71 percent of respondents reported an 8 percent hurdle rate, down from 76.3 percent last year, the study found.

“A small but growing number of funds are pitching sub-8 percent hurdles, accounting for around one-fifth of targeted capital in this year’s survey,” the report said.

Those with under 8 percent can go as low as 4 percent for credit funds, the report said. “Otherwise, if sub-8 percent, it is usually fixed at 6 percent or 7 percent.”

The study said that funds with no hurdle rate are rare — only 4 percent of funds against 7 percent last year. So it was significant when Advent International dropped the hurdle rate on its eighth fund, which closed in 2016 on $13 billion.

At the time, Advent’s move was highly debated because so few large funds had such a structure. While the firm’s seventh fund included an 8 percent preferred return, Fund VIII did not.

Relieving LPs somewhat was that Fund VIII had a European-style distribution structure, meaning the GP had to pay back all LP contributions before starting to collect its 20 percent share of the profits.

Meanwhile, the terms and conditions study pegged 20 percent carry as the market norm, but a few innovative structures have been popping up in new funds.

Some of those structures include ratchet-based carry, where the percentage of carry increases as the fund achieves certain benchmarks; deal-by-deal carry enhancements that include interim clawbacks with placing in escrow a percentage of carry or profits distributed subject to minimum returns.

Other models include hybrid carry, which diverts deal-by-deal carry to LPs until they’ve received amounts equal to the sum of called capital, preferred return and undrawn capital, the study found.

Also included: dual waterfall structures that LPs can choose — European-style distribution in which the LP is charged the full management fee or alternatively deal-by-deal distribution where the LP gets discounted fees.

Action Item: Check out the study here: https://bit.ly/2uxEoRU