The “hurdle rate” or “preferred return” is the rate of return that a private fund guarantees to deliver to its investors before the manager becomes entitled to share in the fund’s profits via its carried interest.
Historically set at 8% compounded annually, it has been a standard feature of private fund economics since the industry’s earliest days. But in the current fundraising boom hurdle rates have come under sustained downward pressure from a number of major private equity firms launching new funds. Will the hurdle survive?
The hurdle rate helps to aligns the economic interests of the GP and LPs. Because the fund has to channel its initial profits entirely to the LPs before the GP can collect carried interest, it motivates the managers to devote their effort to finding good deals. Conversely, if the fund fails to vault the hurdle, the team won’t see any carry.
The hurdle also acts as a form of reward for an investor having to lock up its capital in a close-ended fund for a relatively long period of time – the typical PE fund runs for an initial term of 10 years. Even though the PE secondaries market is growing fast, it is no way near as liquid or frictionless as the public markets.
Besides being nice to their LPs, GPs in the UK have a particular additional reason to stick with preferred return, because recent changes to UK tax law generally require at least a 6% hurdle, among other things, in order to qualify carried interest for capital gains tax treatment on the basis that it is genuinely at risk.
By giving first priority on distributions of profit to the LPs, a preferred return transfers some of the economic risk from the LPs to the GP. A lot of investors value that protection. Some, like Texas TRS, will often refuse to invest in funds that drop their hurdle. But if a fund is successful the preferred return won’t matter quite so much, because it only affects the sequencing of cashflows, not the overall profit-sharing ratio between the GP and LPs.
A preferred return won’t always work in the LPs’ favour. For instance, if the fund is nearing the end of its investment period and hasn’t beaten the hurdle yet, the GP may be perversely incentivised to punt the fund’s remaining capital on unusual or high-risk deals in a list-ditch attempt to hit the jackpot. Since its carry is already ‘underwater’, the GP has little to lose by taking bigger risks, because further losses would only adversely affect the LPs.
Another factor is the rising popularity of subscription line financing. Taking advantage of historically low interest rates, GPs have been using revolving credit facilities to finance fund operations and thus delay calling capital from investors. Since the hurdle rate is generally calculated on investors’ capital from the point of drawdown to the point of repayment, this systematically reduces the amounts payable to investors in the form of preferred return, which rather undermines the utility of having a hurdle.
A few well-known PE managers, including Warburg Pincus and Hellman & Friedman, have never featured a hurdle on their funds, but they are now being joined by a number of other major players in the industry. For instance, Thoma Bravo has, on its last two flagship funds, dropped the hurdle. Advent International eliminated the hurdle on its eighth flagship fund in 2016. Earlier this year, CVC Capital Partners slashed the hurdle on its latest fund from 8% to 6%. Bain Capital and Vista Equity Partners have recently raised funds that offered investors a choice of economics, with a lower (or zero) hurdle offset by reduced carry and/or higher management fees.
Despite lowering or even jettisoning the hurdle, none of these managers has had any trouble raising capital. Advent targeted $12 billion, was massively oversubscribed (in excess of $20 billion) and closed on $13 billion, with 90% coming from its existing investor base. In May, CVC closed on $18 billion, setting a new European fundraising record.
Evidently, although the LP community isn’t happy about the disappearing hurdle, it isn’t refusing to back hurdle-shy managers either. One reason is that the hurdle is only one among many factors that seasoned LPs take into account when doing their due diligence on GPs and fund offerings. Another is that investors are often trading lower hurdle for a better deal on other terms. For instance, Advent softened the elimination of the hurdle by switching to a more LP-friendly waterfall structure. Thoma Bravo cut its management fee on its latest fund from 2% to 1.5%. LPs have also been focusing on improving disclosure and control of fund expenses and reducing leakage through transaction and monitoring fees.
Historically, the hurdle rate has served as a benchmark for the alternative asset class, expressing a GP’s confidence that it can outperform the public markets irrespective of macroeconomic conditions. So is a falling hurdle like the “canary in the coalmine” – an indicator that managers expect lower returns in future?
Certainly, asset prices are very high at present, and PE funds are flush with dry powder. By the end of 2016, PE funds globally had $820 billion of uncalled capital, up from $752 billion a year before; the figure at the end of 2017 will almost certainly be even higher. The average size of funds has also hit record levels. It will be a challenge for GPs to deploy all of this capital, and in the process they will contribute to the inflation of asset prices, which makes it all the more difficult to generate the 15-20% IRR that has characterised the private equity sector in the past.
In some ways, the traditional 8% hurdle is an accident of history, because it originated in the late 1970s and 1980s, an era when interest rates and inflation were much higher than they are now. But since the global financial crisis, interest rates tumbled to record low levels in the developed world and, against most economists’ expectations, stayed low. Not without reason, some GPs question whether an 8% hurdle is fair in current macroeconomic conditions.
On the other hand, it shouldn’t be forgotten that the current era of low interest rates is the real anomaly in modern economic history. Any hurdle rate reduction that justifies itself by reference to interest rates must also admit the real possibility that interest rates will rise over the next 10 years, which is the horizon for a typical PE fund. In the meantime, cheap debt has undoubtedly helped to enhance PE fund returns.
The investors’ trade body, the Institutional Limited Partners Association (ILPA), continues to recommend that funds adopt distribution waterfalls that pay LPs back all contributed capital plus a preferred return before GPs collect carried interest.
Perhaps the main reason that hurdles are up for negotiation at all is that power has palpably swung away from LPs and toward GPs in the last three to four years, particularly the small group of ‘super managers’ able to raise mega-funds (i.e. at least $5 billion).
In part, this reflects large distribution pay-outs from older PE funds in the last two years, which have left many LPs sitting on a lot of deployable capital while being under-weight on alternative assets in their portfolio allocation. It is also a function of stubbornly low interest rates and jumpy equity markets, which make higher yielding alternative investments all the more attractive to investors.
In the current climate, at least, many LPs are simply not willing to walk away from the table if they don’t get their way on terms; and some GPs, who negotiate deals for a living, have capitalised on that.
A large majority of PE funds still use preferred return, and we are not likely to see wholesale change with that in the near future, especially if and when interest rates start to creep up again. It takes a proven and sustained track record to drop or lower the hurdle and still attract investors, and so far only the industry’s biggest and most prestigious firms have conclusively demonstrated an ability to pull it off.
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