When a manager decides on an investment program and how he will be able to sell his program to investors (whether institutional or otherwise), a potentially attractive part to the program would be a hurdle rate.  This basically limits the performance allocation to the general partner. It is a way for the manager to make sure that the investor is compensated before the manager takes his allocation. The hurdle rate used to be a more prevalent feature of hedge funds. In the past couple of years, I’ve seen the use of the hurdle rate decline…but in the past six to eight months I’ve seen a resurgence of the use of the hurdle rate, especially with regard to groups that plan to court institutional investors in the near future.

The two major considerations for the manager with the hurdle rate is:

1. What should the rate be?
2. How will the rate be calculated?

What should the rate be?

Obviously the named hurdle rate is a business point, not a legal point. The manager should consider who his potential investors would be and what they would like to see.  Also, the rate should relate, if applicable, to the investment program. If you have a bond program and your investment objective is to exceed the lehman aggregate bond index, a natural hurdle rate would be that index. For funds with a blue chip bias, a hurdle might be the return of the S&P 500 or the DJIA. However, in these instances it is more likely to see something like LIBOR or LIBOR plus one or two percent as the hurdle rate.

How will the rate be calculated?

There are three ways to calculate the hurdle rate: a hard hurdle, a soft hurdle or a blended hurdle.

1. The hard hurdle – the hard hurdle is calculated on all profits above the hurdle rate. The hard hurdle is the most investor-friendly of the three and provides the manager with limited upside.
2. The soft hurdle – the soft hurdle is calculated on all profits IF the hurdle is achieved. In this instance, in certain situations, if the hurdle rate is achieve, the investor actually would have a higher return if the partnership had a lower return. The soft hurdle is the least investor-friendly.
3. The blended hurdle – the blended hurdle is calculated on all profits if the hurdle is achieved; however, if the hurdle rate is achieved, the return to investors cannot dip below the hurdle rate. The blended hurdle rate has the upside of the soft hurdle (see difference below if a 10% return is achieved) but protects the investor from the undesirable consequences, in certain instances, of the soft hurdle (see 9% return for the soft hurdle).

The chart below shows the mechanical application of the hurdle rate at various return levels. It contemplates a yearly application of a 20% performance allocation and a 8% hurdle rate.

The negative hurdle rate

In addition to the hurdle rates named above, a fund might also have a negative hurdle rate. The negative hurdle rate comes into play when the hurdle rate is actually below zero. Say for instance if the S&P is down 10% for the year and the fund returns 0%, the manager would actually earn a 2% performance allocation, even though the fund did not return anything. For various reasons, the negative hurdle rate is rarely done. There are plenty of issues with this type of hurdle rate, the most important being the fact that it is going to be hard to tell investors that the fund lost money and owes a performance allocation. In practice, funds with the negative hurdle rates have tended, over time, to drop this provision.