A hedge fund’s limited partnership agreement (LPA) with its investors may contain a hurdle rate and a loss-recovery provision (i.e., high-water marks) concerning the hedge funder manager’s compensation.
Background on Hedge Fund Compensation
Typically, a hedge fund manager receives two forms of compensation.
First, the management company receives a fixed annual management fee, a percentage of the fund’s total net assets under management (AUM). Second, the manager receives a performance fee based on the fund’s profits.
For example, a hedge fund may abbreviate its fee arrangement as “2 and 20”. The 2-and-20 structure means a 2% fixed fee on AUM and a 20% performance fee on the fund’s profits. Because of increased competition in the sector, many fund managers have significantly lowered their fees. As of 2020, according to the Hedge Fund Research (HFR) group, the average fee arrangement was a 1.4% management fee and 16.4% performance fee.
What is the Hurdle Rate?
The hurdle rate is the minimum return on investment (ROI) a fund must achieve before the hedge fund manager receives their performance fee.
The hurdle rate is in place because hedge fund investors are looking for superior returns on their money. If an investor is willing to settle for the market or risk-free rate of return, there is no purpose in investing their capital with a professional hedge fund manager.
The investor would be better off buying a diversified basket of index funds in their own accounts and avoiding the asset management fees altogether.
Example Hurdle Rate for a Hedge Fund
For example, a hedge fund with a 2%/20% fee structure sets the hurdle rate at 6% before the fund manager receives any incentive fee. If in Year 1, the fund’s ROI is only 4%, the hedge fund manager does not receive a performance fee even though the fund was profitable. The hedge fund only receives the performance fee once they’ve delivered investment returns that exceed the hurdle rate.
Most hedge fund compensation agreements contain both a high-water mark provision and the hurdle rate requirement.
Many hedge funds are now finding themselves in a position where a performance fee is rarely ever paid. Fund managers rely solely on the fixed management fee as a percentage of AUM.