Hurdle Rate definition:
For those within hedge fund circles, the term might be very familiar. However, while many have heard about it, not everyone knows what it represents and when it is applied.
A couple of years back, Warren Buffett said
that if he had about $1 million to invest, he would be able to bring a return of 50% on this investment. Since a hedge fund mainly invests because it wants to receive some returns (in order to specify a minimum amount that will be returned from an investment) a manager sets the hurdle rate. Essentially, it helps managers to asses the opportunities that might be brought from various projects in terms of returns. Also, the hurdle rate is tightly related to the risk carried by an investment project, so logically, if the investment is more risky, the returns that are expected by the manager are higher, and the hurdle rate is bigger as well.
So, if a hedge fund has a hurdle rate of 12% and it is seeking to invest in a new company, the company that will benefit from the investment must bring a return of at least 12% for the investor. Basically, the concept of hurdle rate can be also used in discounting future cash flows that might come from an investment.
Let's imagine if a fund invests $10,000 in Year 1, and the cash flow generated by this investment amounts to $4,000, $6,000, and $2,000 in the following three years.
By discounting 12% hurdle rate, the sum of cash flows amounts to:
This represents the Net Present Value. Since the NPV is higher than the initial investment of $10,000, it means that a hedge fund with a 12% hurdle rate might consider investing the initial 10 grand.
The term hurdle rate is employed by all hedge fund managers, in order to ensure that they will have some returns on their investments. Also, it is often applied while calculating the fees that a manager will receive.
Hedge fund managers receive a basic fee, which represents a small percentage of the fund's assets, but also receive a fee dependent on the performance of the hedge fund over the year. The hurdle rate, is thus set in order to determine a minimum amount, on top of which a hedge fund manager will get a bonus, or a performance fee. For example, Carl Icahn, the manager of Icahn Capital
, has agreed (in the past) to pay managers a bonus of 7.5% on any profits that exceed a 4% hurdle rate, according to Bloomberg
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