Hurdle rates for private equity funds may go up

After receiving flak globally over their compensation structure, private equity funds may see their hurdle rates going up.

The hurdle rate is the minimum return private equity funds need to achieve before their profits are shared. A hurdle rate of 10 per cent means that the private equity fund needs to achieve a return of at least 10 per cent before the profits are shared according to carried interest arrangement. Carry represents the share of a private equity fund’s profit that accrues to them (usually 20 per cent).

Says Rahim Penangwala, head of private equity (India) at LGT Capital Partners, a fund-of funds, “In theory, both hurdle rates and fees should come under scrutiny since in the last decade, the size of funds have gone up three-six times (and sometimes even more), whereas performance has decreased.”

Industry experts say that limited partners globally have become very choosy about their investments and are demanding more in terms of performance from these funds. Since capital has become scarce LPs are trying to negotiate the terms and ask for better deals from private equity funds.

Adds Penangwala, “Since most of the PE firms now operate and look at PE as an assets under management game (bigger funds, increased frequency of fund-raising, multiple funds), there are two-three ways to keep the PE firms focused on performance. Firstly, decrease in management fees, secondly, increase in hurdle rate and thirdly, investment amount cap per year.

The carry structure too is beginning to change in private equity. According to international news agencies, some of the big buyout funds globally are now agreeing to accept 10 per cent as carry instead of 20 per cent earlier and 1.5 per cent in performance fees as compared to the general practice of 2 per cent.

Also, experts say that the risk-reward scenario has changed completely. Since the capital is undergoing more risk than normal situations, LPs are demanding more in terms of returns. Rajesh Srivastava, chairman and managing director of Rabo Equity Advisors, said, “Hurdle rates are risk adjusted returns, which the investors of private equity funds expect to cover their cost of capital.

What is hurdle rate?

The internal rate of return that a fund must achieve before its general partners may receive an increased interest in the proceeds of the fund. A hurdle rate of 10 per cent means that the private equity fund needs to achieve a return of at least 10 per cent before the profits are shared according to carried interest arrangement.