**📅 Date:** ➤ ⌈ [[2025-05-25-Sun〚👾 Opportunity Cost&Negotiation Power ▪ Hurdle Rate ▪ High Water Mark 〛]]⌋ **👤 Who**： **📌 Time**: **💭 Note:** ➤ The hurdle is based on the original investment. - For example, if the investment is 1M with a 6% hard hurdle, the management fee applies after reaching 1.06 M. ➤ When calculating performance fees that are "subject to net of management fee," we apply the net of management fee to the investment's final value. - If the performance fee is calculated net of management fee: - Performance fee = (1 - management fee) × (terminal value of the investment) ➤ From an economic view, the hurdle rate reflects: - **Opportunity cost** - **Time value of money** - **Risk premiums** ⇩ 🅻🅸🅽🅺🆂 ⇩ **🏷️ Tags**: #💰/Economy **🗂 Menu**: ⌈[[✢ M O C ➣ 05 ⌈M A Y - 2 0 2 5⌉ ✢|2025 - M A Y- MOC]]⌋ ⌈[[✢L O G ➢ ⌈M A Y - 2 0 2 5⌉ ✢|2025 - M A Y - LOG]]⌋ #👾/Private ➤ ⌈[[👾 My Reflection- 📜 Opportunity, Hurdles, and the Subtle Art of Negotiation]]⌋ ➤ ⌈[[💰 L034-Net Asset Value (NAV)]]⌋ ➤ ⌈[[💰 L034 - Hedge Fund Index Biases]]⌋ ➤ ⌈[[💰 L034 - High Water Mark]]⌋ ➤ ⌈[[💰 L034 -Direct Hedge Fund Investment vs. Fund of Hedge Funds]]⌋ **📑 PDF**： **🌐 Link**: ---   ## 🧩 I. What is a Hurdle Rate? - The **hurdle rate** is the **minimum required rate of return** that an investment or project must generate to be considered acceptable by an investor or firm. - It acts as a **performance threshold**: returns must exceed this rate before profits or bonuses (e.g., carried interest) are distributed. - ![[Pasted image 20250526220233.png|#left|300]] --- ### 🔧 How It Works in Funds - If the **fund's return does not exceed** the hurdle rate → **no performance/incentive fee** is paid. - If the **return exceeds** the hurdle rate → a performance fee is calculated **based on the fund’s structure**. --- ## 🧮 II. Types of Hurdle Rates #### 1. Hard Hurdle Rate - The **incentive fee is only charged** on the portion of return **above the hurdle**. - **Example**: - Hurdle rate = 8% - Fund return = 15% - Fee = 20% - Fee is applied to: **(15% - 8%) = 7% excess return** - Investor keeps the first 8% entirely. #### 2. Soft Hurdle Rate - The **incentive fee is charged on the entire return** once the hurdle is surpassed. - **Example**: - Hurdle rate = 8% - Fund return = 15% - Fee = 20% - Fee is applied to: **entire 15%**, not just the excess. --- ### Key - Hurdle rate often equals the **WACC**(Weighted Average Cost of Capital) for corporate project evaluations. - In **capital budgeting**, the hurdle rate is used to evaluate projects based on their **NPV or IRR**: - Accept if **IRR > hurdle** - Reject if **IRR < hurdle** - From an economic view, the hurdle rate reflects: - **Opportunity cost** - **Time value of money** - **Risk premiums** >[!info] >- **Internal Rate of Return (IRR)** >- **Net Present Value (NPV)** >- **Weighted Average Cost of Capital (WACC)** --- ## III. 🏦 Practical Applications #### ✅ Corporate Finance - Internal capital allocation decisions (e.g., factory expansions, M&A). #### 💼 Private Equity / Venture Capital - Fund managers must exceed the hurdle to earn **carried interest**. - LPs use it as a baseline to evaluate fund performance. #### 🏛️ Institutional Portfolios - Pensions, endowments, and sovereign funds set hurdle rates to define: - Investment **policy benchmarks** - **Asset-class return expectations** #### 📊 Valuation - Used as a **discount rate** in **DCF models(Discounted Cash Flow)** for individual securities. --- ### 📝 Summary Reflections > A hurdle rate ensures capital isn’t just employed — it is used **with purpose**. > It enforces discipline in risk-taking, aligns interests between managers and investors, and reflects **where capital is scarce and where conviction begins**. --- ## IV. 🧮 Why Funds Apply a Hard Hurdle Rate >[!info] A **hard hurdle** means the **incentive fee (carry)** is applied **only to the returns above** the hurdle rate. - If a fund earns 15% and the hurdle is 8%, the 20% carry is applied only to the **excess 7%**. --- ### 📌 Why GPs Use Hard Hurdles #### 1. **Investor Trust & Protection** - LPs receive their **minimum required return first** (e.g., 8%) before the GP earns performance fees. - Reinforces fiduciary alignment: GPs only share in gains **if they deliver alpha**. #### 2. **Incentive Alignment** - Prevents GPs from earning fees on **low or market-matching performance**. - Forces capital to be allocated to **high-conviction, differentiated opportunities**. #### 3. **Competitive Advantage** - Emerging managers may offer hard hurdles to **stand out** and attract capital. - Seen as LP-friendly and performance-oriented. #### 4. **Institutional Standards** - Many institutional LPs (e.g., pension funds, endowments) **require hard hurdles**. - It standardizes return expectations and risk-reward frameworks. #### 5. **Combined with High-Water Marks** - Often used together with **high-water marks** to ensure fees aren’t charged again until previous losses are recovered. --- ### V. 💡 Opportunity Cost Perspective #### 📉 Why Hurdles Must Reflect Alternatives - Investors **forego liquid market options** when they commit to private funds. - Example: **S&P 500 has averaged ~6.5% annually** (real return, post-inflation). - If a fund doesn’t offer **significant upside beyond this benchmark**, LPs are better off in **public equities**. #### 🧭 LP Decision-Making | Investment Option | Return | Liquidity | Risk Profile | |-------------------------|--------|-----------|--------------| | S&P 500 Index Fund | ~6.5% | Daily | Market | | Venture Fund (target) | >15% | 7–10 yrs | Illiquid | | PE Buyout Fund (target) | ~12–20%| 7–10 yrs | Leveraged | > 📌 **Takeaway**: If the **hurdle is too low**, investors aren’t compensated for tying up their money in **illiquid, high-risk strategies**. --- ### 🧠 Summary Insight > A **hard hurdle rate** is more than a payout rule — it’s a statement: > “We recognize your opportunity cost. We only win if you win first.” ---