The hurdle rate is a concept used in investing, specifically within venture capital funds, representing a benchmark return that must be surpassed before the fund manager can claim any carried interest. This is the minimum acceptable return on an investment, establishing a threshold to ensure managers are only compensated when they generate significant returns for their investors.
There are typically two types of hurdle rates - "hard" and "soft".
A hard hurdle means the manager only receives payment on the returns that surpass the hurdle rate. Conversely, a soft hurdle means that once the hurdle rate is met, the manager gets paid on all the returns, including those below the hurdle.
The actual percentage set as a hurdle rate can vary, but it is often associated with a risk-free rate of return or a predetermined fixed rate.
The hurdle rate aligns the interests of fund managers and investors by ensuring that managers are incentivised to exceed specific return targets before collecting their performance fees. However, the details of the hurdle rate, such as its level and whether it's hard or soft, can significantly impact the fund's payout structure. As such, investors should understand how these factors might affect their potential returns.
