What does the term 'hurdle rate' signify in private equity?

The term 'hurdle rate' in private equity refers specifically to the rate of return that must be exceeded for general partners (GPs) to begin earning carried interest. This rate serves as a benchmark for performance, ensuring that GPs are incentivized to achieve higher returns for their investors before they receive a percentage of the profits, known as carried interest.

The purpose of the hurdle rate is to align the interests of the GPs with those of the limited partners (LPs) investing in the fund. By establishing a threshold return, it encourages GPs to work towards maximizing investment performance. Only once the returns of the fund surpass this established rate can GPs share in the profits, reinforcing the principle of rewarding performance that benefits investors.

This concept is critical in private equity as it impacts the way investment strategies are planned and executed, influencing both the risk and return profile of the investments made by the fund. Understanding the hurdle rate is essential for analyzing compensation structures within private equity funds and evaluating the likelihood of GPs earning additional returns through carried interest.