Hurdle rate: Definition, formula, and private equity impact

What is hurdle rate?

A hurdle rate is the minimum required rate of return that an investment must achieve to be considered worthwhile by investors or fund managers. It serves as a benchmark for evaluating potential investments, reflecting the opportunity cost of capital and the specific risks associated with an investment project or fund.

In essence, the hurdle rate is the threshold that an investment’s expected rate of return needs to exceed for it to be approved, ensuring that only opportunities with risk-adjusted potential returns move forward.

Hurdle rate in private equity

In private equity, the hurdle rate plays a crucial role in structuring profit-sharing arrangements, particularly regarding carried interest. Typically, private equity funds set a contractual hurdle rate (often around 8%) which limited partners (LPs) must receive before the general partner (GP) is eligible to earn carried interest, usually a percentage of profits above the hurdle.

This mechanism aligns the interests of PE fund managers and LPs, incentivizing managers to pursue investment opportunities that outperform the minimum required return and ensuring that LPs are prioritized in profit distributions.

There are several factors that influence what is considered an appropriate hurdle rate—including current interest rates, inflation rates, market volatility, and level of risk. For example, high-risk investments and competitive markets usually demand higher hurdle rates.

Hurdle rate vs internal rate of return (IRR)

The internal rate of return (IRR) and the hurdle rate are often discussed together, but these financial metrics serve distinct purposes:

While IRR measures the actual annualized return generated by an investment, the hurdle rate is the minimum acceptable rate of return set in advance. An investment is considered successful if its IRR exceeds the hurdle rate; otherwise, it may be rejected or restructured.

In capital budgeting, fund managers often use hurdle rates as the discount rate for evaluating the net present value (NPV) of future cash flows. However, not all discount rates are hurdle rates. The hurdle rate explicitly incorporates risk and opportunity cost, serving as a performance benchmark for both investment decisions and profit-sharing.

Hurdle rate formula

The hurdle rate is typically calculated by adding a risk premium and other relevant adjustments to a baseline rate, such as the risk-free rate. A common formula is:

Hurdle rate = Risk-free rate + risk premium + inflation premium (if applicable) + other adjustments

In private equity, it’s common to use the weighted average cost of capital (WACC) as a baseline, then add a risk premium to reflect the specific risks of each investment.

Hurdle rate calculation example

Suppose a PE fund is considering a new investment:

• Risk-free rate: 3% (e.g. 10-year Treasury yield)

• Equity risk premium: 5%

• Industry-specific risk premium: 2%

• Inflation Premium: 1%

Hurdle Rate = 3% + 5% + 2% + 1% = 11%

This means an investment must generate at least an 11% return before profit-sharing mechanisms like carried interest are triggered in a private equity context.