When Blackstone started marketing its debut infrastructure fund, it did so with a hurdle rate of just 5 percent. By the time it held a $5 billion first close this summer, that had been nudged up to 6 percent after investors had expressed concern that 5 percent was simply too low.
The hurdle rate – or preferred return – is the target a manager must surpass before they start receiving carried interest. In infrastructure investing, as in private equity, 8 percent is the norm and has been basically since the dawn of time. “That really has been sticky across both private equity and infrastructure,” Kelly Deponte, managing director at San Francisco-based placement agent Probitas Partners, told Infrastructure Investor.
While Blackstone had to concede a little ground to investor pressure, they still managed to enter a club of managers that have knocked the hurdle down from the conventional 8 percent. In private equity, CVC Capital Partners’ seventh flagship fund – a €16 billion whopper that closed last year – has a hurdle rate of 6 percent, and Advent’s $13 billion eighth flagship fund – closed in 2016 – has no hurdle at all. In fact, these days around a quarter of funds operate with a hurdle of less than 8 percent, according to research from law firm MJ Hudson.
When it comes to negotiating terms, GPs will say the process is less about which way the “pendulum of power” has swung between them and the investors, and more about ensuring the fund is fit for purpose for everybody’s interest. Still, it is tricky to imagine the conversation in which the new lower (or absent) hurdle rate is introduced.
“So, we’re dropping the hurdle rate…”
“Because we are in a low-return, low-interest rate environment.”
“You don’t think you are going to make 8 percent?”
“Of course we will! Nevertheless… ”
It’s an oddly circular conversation.
One reason that investors let it slide is that – while it provides some comfort – its importance to LPs may be overemphasised, as it should not affect overall returns. As Stephen Moseley, head of private equity at Alaska Permanent Fund told sister publication Private Equity International last week: “We’ve backed funds with no hurdle rate and I don’t love that missing element… it will often affect timing of cashflows, which affects IRRs and overall risk… but I’d happily trade away a point on the hurdle rate for lower carry, a European waterfall versus an American waterfall or lower management fees.”
It’s also worth remembering the hurdle is not a 100 percent perfect mechanism when it comes to aligning manager and investor interests. Most of the time it works as intended: the LPs start seeing returns before the GP begins making significant gains. But if a fund is just outside the carry, then it could incentivise greater risk-taking. And if things go wrong and carry becomes a distant and unobtainable goal, then the incentive to maximise is significantly diminished.
In the grand scheme of things, LPs may be prepared to give ground to in-demand GPs on the hurdle for these reasons. Whether they like it or not is another consideration altogether.
Toby Mitchenall is senior editor of Private Equity International. Write to him: firstname.lastname@example.org