Hurdle rate
What is Hurdle rate?
A hurdle rate is a minimum return or reference level that must be met before a performance fee, carried interest, or investment approval condition applies.
The displayed hurdle should specify simple or compounded, fixed or floating, reset frequency, benchmark source, spread, day count, catch-up, and treatment of negative periods. Tiny drafting differences can materially change fees, so a generic annual percentage is not enough for calculation or comparison.
When a benchmark is discontinued or negative, replacement and floor provisions can become economically important and should be established before the event occurs.
Fee hurdle
In a fund, the hurdle may be fixed or linked to a benchmark, cash rate, or preferred return. A hard hurdle charges incentive compensation only above the threshold, while a soft hurdle can allow a fee on the full gain once crossed. A catch-up can then allocate additional profit to the manager under a stated formula.
Compounding and timing
Terms may use simple or compound return, annual or deal-level periods, daily accrual, and different reset or crystallization dates. Floating hurdles require a defined source and observation method. Contributions, withdrawals, distributions, currency, and partial periods affect investor-specific calculations, so one headline percentage cannot reproduce the result.
Investment hurdle
Companies and managers also use hurdle rates as required returns for projects or securities. These can reflect funding cost, risk, opportunity cost, or policy. Applying one corporate hurdle to projects with very different risk can accept weak investments and reject good ones. The fee meaning and capital-budgeting meaning should not be conflated.
Example
A fund earns 10% with an 8% hard hurdle and 20% fee. A simplified fee is 20% of the two points above the hurdle. Under a soft hurdle, it might be 20% of the full ten points after the threshold is met. Catch-up and compounding can produce another result, illustrating why documents control.
Practical review
Model returns just below and above the threshold, loss and recovery, subscriptions, withdrawals, benchmark changes, and crystallization. Confirm gross or net basis, fees included, day count, high-water mark, catch-up, clawback, and reset. Avoid treating a preferred return as a guaranteed payment or a hurdle as evidence that risk is controlled.
Sources and further reading
- How Fees and Expenses Affect Your Investment Portfolio, Investor.gov, U.S. Securities and Exchange Commission