We are seeing an uptick in fund startups right now and managers are looking for any way they can to differentiate themselves. An option many managers are going with is a hurdle rate. A hurdle rate requires a return of a certain level before an incentive allocation is charged.
Typically, the hurdle rate for a fund is a set percentage somewhere between 4% to 6%. However, depending on a fund’s strategy, it may make more sense to tie the hurdle rate to some metric, such as the S&P 500 or the DJIA.
There are two main types of hurdle rates: a hard hurdle and a soft hurdle.
A hard hurdle charges an incentive allocation on only the gains that exceed the hurdle rate. For example, if a fund has a 5% hurdle and achieves 6% return (prior to the incentive being charged), the fund manager would only earn an incentive allocation on the 1% over the hurdle.
Alternatively, a soft hurdle charges an incentive allocation on all gains so long as the hurdle rate is met. In the previous example, an incentive allocation would be charged on the full 6%.
One additional factor to consider is whether the hurdle rate will be compounding or non-compounding. A compounding hurdle rate compounds off of the prior year hurdle rate if an incentive allocation was not charged in the prior year. If an incentive allocation was charged in the prior year, the compounding hurdle rate would be calculated off of the beginning of the year balance.
In the case of a non-compounding hurdle rate, the hurdle rate is always calculated based on the beginning of the year balance. However, non-compounding hurdles are often subject to a high-water mark, which requires the manager to make up any previous losses before an incentive allocation is charged.
Below you will find an example calculations of incentive allocations assuming a 5% hurdle and a 20% incentive allocation. Four different calculations are shown below illuminating the different impacts these features will have.
The way the features of a hurdle are defined will lead to different results. Therefore, it’s important to ensure hurdles are well defined in your offering documents to alleviate costly headaches later.
How Wipfli can help
We are always happy to discuss options and wording with fund managers to ensure the intended objectives are achieved. Contact us for more information.
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