Advent International became a news-maker in 2016. Not because of its successful US$13-billion fundraising, but because the venerable firm’s latest fund was oversubscribed at a reported US$20 billion despite not featuring what has been to date a mainstay of private equity funds: the “hurdle” or “preferred return”.
Hurdle rates refer to the minimum rate of return, typically set at 8 percent, that the general partner must meet before it begins to collect carried interest. Once enough capital is returned to investors so that the hurdle is met, the GP “catches up” by receiving the next distribution amounts, until it has received its share of the preferred return, and then subsequent amounts are shared between the investors and GP (often on a 80:20 basis).
For a successful fund that generates enough return to reach this last stage of the distribution waterfall, the hurdle affects the timing of cashflows between the investors and the GP, but not the overall sharing.
With Advent’s successful fundraising, certain market participants may have begun to question whether the use of hurdle rates may be changing. Did Advent start a trend?
Are hurdle rates outdated?
Hurdle rates have traditionally been viewed as a form of insurance to ensure partners’ interests are aligned by guaranteeing that limited partners see a return on investment before GPs can start to collect their carry. A hurdle rate has historically been accepted as a way to reward LPs for the relatively long period their capital is tied up with a fund. It is also thought to promote “good” behaviour as it incentivizes buyout funds to go out and find deals and thus generate returns, rather than just hold the capital.
The counter position to this is obviously that a hurdle can promote “bad” behaviour that may prejudice LPs. For example, where the hurdle has not been met and yet most of the capital of the fund has been deployed, the GP may be tempted to take a greater risk in an effort to produce an outsized return in order to meet the hurdle.
A further argument in favour of eliminating or at least reducing the hurdle is that to many people it is an outdated notion in this era of low interest rates. The typical 8 percent hurdle rate was created more than 30 years ago when interest rates were soaring. PE firms had to earn investors a better return than bank CDs, which is why the preferred returns made sense in the 1980s.
Today, PE firms may be inclined to push back on the LPs because the macroeconomic environment has changed substantially. The rate of return for the PE asset class has diminished and interest rates have been low dating back to the early 2010s. And although interest rates are expected to rise in the United States, the rate increase is expected to be gradual and not reach levels of the 1980s when most PE firms were being launched.
Given the different views of hurdles, the current market, and the fact that Advent was not affected in its recent capital raise, the question remains whether there will be further movement away from this feature in the United States and Canada.
Possibly. As one placement agent who sees a lot of funds raised has said, there has been a lot of chatter about hurdle rates for three years now and there have certainly been more funds reducing, or at least trying to reduce, their hurdle rates.
CVC Capital Partners launched a fundraising effort at the end of 2016 to raise what will be its seventh fund. CVC cut its hurdle rate to 6 percent from 8 percent and still expects to cap the fund at €15 billion by the end of the second quarter of 2017, according to Buyouts. Certain other top-performing buyout funds, like Warburg Pincus and Hellman & Friedman, have never used hurdle rates, which has clearly not impeded their ability to raise capital.
A distinction should be made here, however, as it is not uncommon for venture capital firms to forgo hurdle rates, at least in the United States. The Canadian market continues to hold to inclusion of the hurdle rate for both PE and VC funds, and often at the traditional level of 8 percent.
Still widely in use
Despite the movement away from the hurdle by these global super-funds and among U.S. venture funds, and acceptance of this position by LPs across the globe, including Canadian institutional investors, the majority of PE firms still offer a hurdle rate.
In fact, according to Preqin’s 2017 Global Private Equity and Venture Capital Report, firms not providing any hurdle rate actually fell to 13 percent from 19 percent, and the proportion of firms with a hurdle rate higher than 8 percent increased from 8 percent to 22 percent, in 2016. These data suggest that while certain funds can deviate from the norm, most PE firms are not able to successfully omit the hurdle and still successfully raise new funds. It clearly takes a proven and sustained track record to forgo the hurdle and attract investors.
It’s also important to note that even though some PE firms aren’t using hurdles they are making certain other concessions.
For example, Advent is using a European waterfall structure in which the PE firm must pay back all of the investor’s contributed capital before collecting carried interest, which is in contrast to the American waterfall system where many buyout firms collect carried interest on a deal-by-deal basis, provided they have returns to the investor’s capital contributed on realized transactions and sometimes additional items, such as related fees and expenses, according to Buyouts.
Also, while LPs do not like the change in hurdle rates, most LPs are more concerned with the net returns provided by a fund rather than one perk or fee. LPs are carefully reviewing management fees, transaction fees, track record and hurdle rates and balancing these factors against net returns.
One part of the equation
The hurdle rate is only one part of the equation and net returns will be the determining factor of whether an investment is ultimately made. No LP will invest in a buyout fund that has a favourable hurdle rate, but an unproven track record.
While hurdle rates may be considered out of favour with some funds today, that may not be forever. The pendulum between the GPs and the LPs may swing back into the LPs’ favour in the future, although the top private equity firms that prove themselves now with smaller hurdles or no hurdle may maintain an advantage.
Mary Abbott is a partner in Osler, Hoskin & Harcourt LLP‘s corporate practice. She advises domestic and foreign companies, as well as Canadian pension plans, on mergers and acquisitions, complex corporate restructurings and securities law matters, including financings.
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