It's been a while since I posted but a reader recently asked me to comment on Hurdle rates. For those of you not familiar with what a hurdle rate is, it is generally the preferred rate of return an investor requires to make an investment. Some refer to it as "cost of capital". If you consider the many options of where money can go to make a return, for an investment to be attractive it should exceed the most commonly available rates of return. There are many differing opinions on what this common rate of return should be. For example, some people feel that a good preferred return is that of what money would cost to borrow from a bank such as 7% on a fixed 30 year loan or a few points above LIBOR. Others may use a benchmark of the average return of a broad stock index such as the S&P 500.
Another way to look at the hurdle is the percentage return after which a fund manager can charge fees. For example a manager may say that his fees will only be charged on the return in excess of the hurdle. The logic is essentially that the investment should return better than a commonly available return and thus only fees should be paid on that excessive return.
I have never been a fan of hurdles or preferred returns in private equity. The main reason is that I am not a nickel and dimer and if I am investing in an investment looking for an outsized gain I am not going to fuss over the terms of a preferred return. If I wanted a hurdle type of return I would just put my money in a mutual fund or buy a piece of commercial real estate and get a good cap rate. When I invest, I want the manager to make big returns and be rewarded on the back end for the great return.
It is sort of analogous to investing in public equity for dividends. I am not a dividend investor and would never invest in a stock for its dividends but more for its appreciation. Additionally, in a private venture type investment, taking a dividend in a startup does not make sense to me because you want the cash to stay in the company to add value to the equity. An LBO is a different scenario because the company is cash flow rich and taking a dividend should not weaken the company materially.
Thus to me the hurdle rate should be a non-issue and in a private deal where I am looking for a good return, I do not want the manager to focus on the hurdle. I would rather that it be clean and simple. I want to be able to calculate the return and fees that I paid to the manager in my head or on the back of a napkin, not through a complicated spreadsheet.
If I am investing in a fund, I am looking to build a relationship is someone who can earn good returns over any cycle. I may negotiate some terms or fees, but the hurdle certainly is not one of them. I would rather go with a talented manager with a low hurdle than a first-timer with a high preferred return.
Love the blog, and this was a great post. I've never quite comprehended why people go into a deal with a "hurdle rate mentality". Of course you want the highest IRR possible, but when making the investment, I think some deals that could turn out to be phenominal are passed over, and other deals that end up flopping shouldn't have been invested in to begin with. Keep up the great writing.
Posted by: Fast-Eddie-K | January 26, 2009 at 09:39 AM
What about building a relationship with an individual private company? Are there still investors who are interested in companies with great long term potential and are willing to back such a company for years of development? What kind of returns does a company need to offer, and within what time, to attract an investor to a long term project?
Posted by: Margaret | February 25, 2009 at 10:11 AM