The Hurdle Rate Debate: Are Private Debt Managers Lowering the Bar?

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Amid the latest round of Direct Lending fundraising, a disturbing theme has started to emerge. Many managers, it seems, are rather keen to lower their hurdle rates – the point at which lucrative catch-ups and performance fees kick in. It is a step that a number of their private equity counterparts have already taken.

Why is it appropriate that LPs should bear most or all of the pain from a less rewarding investment environment

Some are sounding out the idea; some have already tried to market their latest offerings; most have not (yet) succeeded in taking a step that, for LPs, would be hard to stomach.

Hurdle rates are a rather shadowy subject. Often the height of the hurdle, and the structure that kicks in when it’s reached, receive less attention than management fee and carry percentages, perhaps because the latter are often open to negotiation while the former are enshrined in fund T&Cs. Yet the hurdle is, arguably, the most important part of the fee leakage puzzle. Indeed, we see examples where managers with lower management fees end up taking home more money purely because they reached the same (net-of-management-fee) hurdles sooner than they otherwise would have done.

We certainly do not believe that Direct Lending managers’ hurdle rates have been too high in recent years. Indeed, in some cases the threshold has already been a little too low and there is still, on average, too much leakage in the net performance figures.

As a rule of thumb, our view is that the hurdle should be no lower than 2% beneath the fund’s expected return (e.g. 6-8% expected return, 5% hurdle) if a 100% catch-up is employed. Ideally the figure should be less than 2%: the smaller the gap between the investor’s performance expectations and the manager’s performance fees, the better the alignment.

FALLING RETURNS

If managers were lowering their expected return figures for newer funds, we would not be surprised to see a matching reduction in the hurdles, since otherwise the economics of running such funds would be far less profitable.

It would not be an entirely palatable argument: why is it appropriate that LPs should bear all or most of the pain, financially speaking, from a less rewarding investment environment? But it would at least be consistent. It would also be understandable, since greater competitive pressure among lenders is evidently squeezing the margin(the yield above the LIBOR base rate) available on like-for-like loans (see Direct Lending: What’s Different Now? bfinance, March 2017).

Private debt managers' fees are the rather strange result of their hybrid descent.

Yet here’s the rub: they (apparently) aren’t. The expected returns pencilled on funds being raised in 2017 are broadly the same as before, except in cases where strategies are significantly different.

There is one particularly strong reason why managers may expect their returns to stay broadly similar, despite falling margins: higher interest rates. This rising tide could buoy up managers’ absolute returns, since floating rate loans dominate portfolios. And unlike banks, which would face a rising cost of capital (equivalent to the rising LIBOR) for the money they lend out to businesses, asset managers – whose pot of cash comes from LPs – wouldn’t feel the margin squeeze in practice.

SHRINKING MANAGEMENT FEES

The mathematics of maximising fee load are relatively straightforward: if a manager knows that the management and performance fees are likely to be a little lower on the current fund than they were in the past, lowering the hurdle rate can offset the difference.

The past few years have seen management and performance fees for Direct Lending coming down significantly, particularly in Europe where the sector has evolved rapidly and median base fees have fallen by a third since 2014 (Investment Management Fees: New Savings, New Challenges – bfinance, May 2017). For a manager looking to maintain consistent economics, hurdle rate adjustments may appear to make sense, despite the harmful impact on alignment.

STUCK IN THE MIDDLE

Private debt managers’ fees are, in some ways, the rather strange result of their hybrid descent. The sector has strong ties with two very different parts of the investment landscape: Leveraged Loans and High Yield Debt on the one hand; Private Equity on the other. Their fee structures, however, have far more in common with private equity funds: the only real differences are the percentages used. The “100% catch-up,” for instance, is applied by the vast majority of managers.

Despite the practical similarities with credit, the relationship between the private debt and private equity sectors is much more intimate. Many private debt funds are launched or run by private equity firms. Staff straddle or transition between the two worlds and expect compensation to suit. These dynamics bring their own pressures to private debt managers’ economic arrangements.

From a completely abstract perspective, ignoring industry evolution and simply looking at the investment or administrative realities, the adoption of the private equity fee model can be rather difficult to justify. PE managers have the potential to generate significant upside; private debt does not. PE managers may make a case for a 100% catch-up by pointing to operational value-add during the holding period; the argument is less clear for Direct Lending managers, whose monitoring, controls and work-outs do require manpower, but not the same level of active involvement. It’s worth noting that in Real Estate Debt and Infrastructure Debt, where returns in recent years have commonly been in the 2-4% range, carry-only models are mainstream.

There has been no apparent move towards reducing catch-ups or implementing carry-only models – steps that we would warmly support in the interests of investors. There has also been no sign yet of management-fee-only structures, which would bring private debt in line with much of the credit space.

Management and performance fees for direct lending funds have improved noticeably during the past few years, with investors benefiting from more competitive pricing. Yet fee structures - equally significant - have not moved in LPs’ interests. Against this backdrop, a reduction in hurdle rates could represent a backwards step.

Hopefully the negative reaction among investors, together with rising competition among fund managers, will dissuade firms from following through on such changes.