Not many funds have come back to market since interest rates increased drastically, which makes sampling harder, however, whilst so far only a few fund managers have increased hurdles, several have felt pressure from investors to justify maintaining the same waterfall structure given the current market environment.
One of the key concerns of increasing hurdles is that market conditions may change, and managers may be left with hurdles that are too high. This could lead to a misalignment of GP and LP interests which does not benefit either party - a hurdle that is too high may disincentivise GPs or incentivise them to take on excessive risk. For GPs that do not wish to raise their hurdles, this article will explore options to improve alignment and appease investors who wish to see some change to fund terms.
Floating hurdle rates are not a common feature of private debt funds. However, in recent months they have been increasingly mentioned by both managers and investors as a potential alternative to address interest rate volatility. Typically, hurdle rates in private debt funds have a fixed percentage (e.g. 5%). Given that most private debt funds lend on a floating rate basis, a floating hurdle rate may be better suited to align the GP incentive with the underlying assets.
A floating hurdle rate varies according to a reference rate1 guaranteeing that the manager is not being compensated solely due to a market-wide rise in interest rates. Because the objective is to align performance compensation to underlying instruments, the reference rate used for the hurdle should be consistent with the fund’s underlying loans and consider the market/geography and the currency most relevant for the fund’s strategy. This implies that determining an appropriate reference rate is more challenging for funds with a greater global focus. A margin, also known as spread, would also typically be added to the reference rate. As with fixed hurdles, floating hurdles can be compounded annually in arrears based on the previous year’s average reference rate. The challenge however is in determining the margin over the reference rate.
Hurdle rates, often referred to as preferred returns, set the minimum return required before GPs can start sharing in the profits with LPs. In private debt, these are typically “soft” hurdles meaning that the GP receives carry on the entirety of the profits (if the hurdle is met).
In practice, there are few examples of private fund managers using floating hurdle rates. Some examples can be found in business development companies (BDCs). Notably, Barings has had a floating hurdle for one of its BDCs since 2020 and TCW suggested in 2017 (a time when interest rates were rising in the US) that Hercules Capital should also adopt floating hurdles4 . Still, from publicly available information, private credit BDCs launching in 2023 are still opting for a fixed hurdle.
Most hurdle rates in private debt are “soft” meaning that the GP receives carry on the entirety of the profits (if the hurdle is met). This means that, after the LP receives the preferred return there is an imbalance in carry distributions that must be rectified. The catchup period addresses this by awarding the GP a higher percentage of the profits until the profit split determined by the carried interest agreement is reached.
The percentage distributed to the GP during the catchup period can vary. For example, an 80% catchup implies that during this period, 80% of the profits are distributed to the GP and 20% to the LP until the profit split is reached, whereas with a 100% catchup the entirety would go the GP. Historically, the 100% catchup has been seen as the standard term in private debt – this has been the case for over 80% of the direct lending funds we have established in the last five years.
The following graph illustrates the impact of different catchup rates on the manager’s carried interest.
With a 70% catchup, the GP only gets to the agreed carry split if the fund returns 11.2% compared to 10% with a 100% catchup. This illustrates how catchups impact GP incentives by requiring a higher effective rate of return to get to full carry. It also illustrates how catchups do not impact profit distributions when the hurdle is comfortably surpassed i.e. the catchup does not correct a large misalignment between the hurdle rate and the target return.
In the following example we use typical direct lending terms, 5% hurdle and 10% carry, to illustrate how a 50% reduction in catchup may be a better tool for alignment than increasing a hurdle by 50 basis points, which, as mentioned in our previous article, is the most common increase we currently see.
By lowering the catchup to 50%, rather than increasing the hurdle by 50 basis points, the GP starts participating in the profits earlier, but only reaches the agreed carried percentage later when compared to a higher hurdle where the catchup is kept at 100%.
This can be a helpful tool to align GP and LP interests whilst simultaneously diminishing the risk that if fixed hurdles were increased for current vintages and then interest rates came down, managers could be incentivised to take on excessive risk to get into carry.
Currently investors believe there is potential for higher returns in private debt and therefore want higher hurdles to ensure managers are incentivised to make the most of current opportunities. Essentially, investors do not believe private debt managers should receive high levels of carried interest for returns that can be achieved in more liquid markets.
Another way to incentivise managers to achieve higher returns is by using a tiered approach for carried interest - the carried interest percentage increases as the fund hits certain return benchmarks. This approach has typically been seen in private funds with a higher upside potential, such as venture capital, to reward managers for extraordinary returns. They have also been seen in continuation funds more recently. However, it could also be applied to the private debt context to align different levels of return to appropriate reward.
