Arguments over the height of a hurdle

When considering the merits of private debt relative to other investment options in today’s world, one of the most compelling arguments is the floating-rate nature of many loans – meaning that rising interest rates, a painful experience for many, are something to put a spring in the step of private debt fund managers given their potential to boost returns.

But managers should perhaps modify their celebrations if they want to avoid investors forming the view that they have things a little too good. This dynamic is manifesting in a debate around hurdle rates – the minimum return that needs to be delivered before a manager begins sharing in the fund’s profits. A guest feature we published this week by Margarida Ferreira of law firm Macfarlanes examines whether hurdle rates are simply now too achievable. As with many things, it discovers there are two sides to the argument.

On the one hand, investors opposed to current hurdle rates say, not only are the hurdles too easy to jump over, they are but one manifestation of a lender-friendly environment in general. With the terms and conditions of transactions having moved in favour of lenders and against borrowers, there are multiple ways in which lenders are getting a great deal. They should be prepared to hand something back.

One the other hand, apologists for current hurdle rates say that things don’t stay the same for very long. Over the lifetime of a private debt fund, typically between seven and 10 years, very different market conditions are likely to prevail – some in favour of lenders, some against. Rates may start to fall, capital may prove difficult to deploy, an increase in defaults may present operational challenges. No one can blame managers for making the most of it while the going’s good because, in the end, things have a habit of averaging out.

Earlier this week, we published the latest global fundraising figures from the beginning of the year to the end of the third quarter. In common with other asset classes, private debt has found the fundraising trail to be a lonely and challenging place in 2023. Managers cannot afford to be complacent. But then, claims are being made about the current vintage representing a golden era. So perhaps investors can’t afford to be too complacent either. Hurdle rates are an interesting point of reference amid this unfolding GP/LP dynamic.

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Write to the author at andy.t@pei.group.