The hurdle rate is an important concept to understand in hedge fund compensation and fees. In the following video, I explain what a hurdle rate is and how it is used by hedge funds and investors.
Video Transcript/Summary: The strategies and tips provided within this video module include:
- A hurdle rate is a set performance fee that must be achieved before any performance fee can be calculated and paid to a hedge fund manager.
- Most hedge fund managers charge a management fee and a performance fee. The management fee is typically 2%, while the performance fee is generally 20%.
- An example of a hurdle rate might be an inflation figure. Therefore, if inflation is running at 3.2%, the hedge fund manager will only get paid their 20% performance fee if the return they achieve for their client, is great than this 3.2% hurdle rate of inflation.
- The hurdle rate was introduced as a way of ensuring that the performance fee charged by hedge funds was justified and to protect clients from paying for returns that could be obtained elsewhere, without taking on as much risk.
- Over 95% of the hedge funds our firm is active with, operates with a hurdle rate in place, especially small-to-mid size hedge funds that are hungry to grow capital.
- Hurdle rates tend to make the deal between clients and hedge funds that bit more fair.
Transcript for Hurdle Rate Definition
Hello, this is Richard Wilson and welcome to this short video on hedge fund training. It’s just going to be about one topic, one term called the “Hurdle Rate.” And you might have heard hurdle rates in the news and the hedge fund managers, marketing materials, in one of the books you’re reading for the CHP designation. And a hurdle rate is really a set performance figure that must be achieved before any performance fee can be calculated and paid to a hedge fund manager.
So to back up one step, most hedge fund managers charge a management fee and they charge a performance fee. Typically, the management fee is 2% and the performance fee is 20%. What this is saying is that, for example, if an institutional investor is looking at investing in a hedge fund and they know that inflation is 3.2%. And they go to the hedge fund manager and the hedge fund manager was saying “Well, we’re going to charge 20% for any performance,” while on the institutional investor’s mind he can get something that can give him an inflation rate return at little or no risk.
And so the hedge fund manager wants to be able to say “Okay, we won’t charge you our performance fee until we beat that 3.2% inflation benchmark.” So until we beat inflation, we won’t consider it performance or out performance and we won’t charge you that fee. And so a hurdle rate is something that was kind of invented to take out that objection to investing in hedge funds and they’re going to charge for all of this performance which really isn’t data performance. If you’re charging these high fees we want something that’s above and beyond what we can get for less fees and less risk elsewhere.
And so that is really why the hurdle rate exist and you’ll see that over 95% of hedge fund managers that our firm has interacted with and the thousand managers that we’ve seen, people have hurdle rates in place and especially small to mid-size hedge funds which are hungry to grow capital. It just makes sense having a place and it kind of makes the deal on both sides a little bit more fair.
So there’s a short definition and explanation of hurdle rate, why it exist, why it’s in place. If you have any more hedge fund questions, please feel free to submit it to us and thank you for your time today.
Understanding the hurdle rate is a key area of hedge fund compensation and fees. I hope that this video provided a good definition of the hurdle rate.
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