The hurdle rate is the minimum rate of return that the hedge fund manager should generate before he or she can charge a performance fee. This rate is usually a benchmark interest rate such as Libor or the one-year T-rate plus a fixed spread. The underlying concept is that investors can earn this return in a relatively safe way by buying money-market instruments or by buying government bonds. As such, the hurdle rate represent the opportunity cost of investing the money somewhere else.
Example of hurdle rate
To see how a hurdle rate impacts the amount of incentive fees investors have to pay, lets calculate the performance fee for a hedge fund that has such a hurdle in place. Suppose the manager sets the rate equal to Libor plus 20 basis points.
After one year, suppose the fund performed quite well and returns 20%. Over the same period, Libor was 2%. Adding the spread (20bps), the hurdle rate equals 2,2%. In this case, the manager can charge a performance fee of 20%. However, in practice there are two possibilities in which performance fees might be determined. First, the hurdle rate provision could state that incentive fee can be charged only on the profits above the hurdle rate. In that case, the incentive fee earned equals
The second possibility is that, once the hurdle is met, the performance fee is charged on the entire profit. In that case, the performance fee equals
If the fund manager had returned less than 2.2%, he would not have earned any performance fee at all.
Hurdle rate in hedge funds
In general, hurdle rates are less common than high-water mark clauses. While both can in principle be combined, such a practice is also uncommon.
We explained the concept of a hurdle rate. Itrepresents the minimum return a manager should generate before he or she can earn a performance fee. It is sometimes, although not always, used by hedge funds.