In a typical private equity commercial real estate transaction structure, a property’s income and profits are divided between investors and the private equity firm using a “distribution waterfall” methodology. One of the key components of this methodology, which has a major impact on the cash flow split, is a metric known as the hurdle rate.
In this article, we are going to define what a hurdle rate in private equity is, describe why it is important, and provide an example of how hurdle rate is used in a typical transaction. By the end, readers will be able to use this knowledge to determine if a private equity investment is a good fit for their own investment objectives.
At First National Realty Partners, we utilize a waterfall distribution method in all of our deals. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
What is a Hurdle Rate in Private Equity?
In a private equity transaction structure, there are two groups of participants – the private equity firm – sometimes referred to as the general partner, and individual investors – sometimes referred to as the limited partner(s) or LPs. The private equity firm is in charge of finding, financing, and managing the real estate asset while investors provide equity capital. Since they are both involved in the transaction, one of the major deal points to consider is how the property’s income and profits are split between the private equity firm and their investors.
In most cases, the property’s cash flow is distributed according to a “waterfall” that is designed to both provide a profitable return for investors and incentivize the private equity firm for performance. One of the key elements of the waterfall structure is the “hurdle rate” or the point at which the cash flow split between the private equity firm and their investors changes.
In order to understand how this works, an example is helpful.
How Hurdle Rates Work In Private Equity, an Example
Suppose that a private equity firm found a property with a price of $3M. In order to purchase it, they have lined up $2M in debt from a bank and have raised $1M from investors. Of the $1M, assume that the private equity firm provided $100,000 (10%), and investors provided the remaining $900,000 (90%).
Now, assume that the property produces $180,000 annually in Net Operating Income (Gross Income, less operating expenses). These funds are first used for debt service, assume $100,000, and anything left over is distributed to investors according to their proportionate share of ownership.
To start, these funds would be split, 10% to the private equity firm and 90% to the investors. But, remember, the point of the waterfall structure is to incentivize the private equity firm for performance. So, as the return they deliver grows, their share of income and profits also grows. It changes, each time it reaches a hurdle rate.
So, in this example, suppose that when the return is between 0% and 8% annually, the split is proportionate to the original investment (10%/90%), but above 8% – the hurdle rate – the split changes to 20% for the private equity firm and 80% for the investors. In this scenario, the private equity firm does well when they deliver a higher rate of return than 8% because they get a larger share of income. But, the investors also do well because they are receiving a high return on their capital.
How To Calculate The Private Equity Hurdle Rate
The hurdle rate is not always the same. It is unique to each transaction and the structure/fund terms are defined by the private equity firm and described in the investment’s offering documents.
Generally, the hurdle rate in private equity is calculated using one of two common commercial real estate return metrics: Internal Rate of Return or the equity multiple.
The Internal Rate of Return (IRR) is a metric that measures the rate of return for each period that capital is invested in. The Equity Multiple measures the ratio of total cash received to total cash invested. In either case, the hurdle rate – and its calculation methodology – will be defined in the offering documents.
The Importance of Understanding The Hurdle Rate
It is absolutely critical that investors read and digest an investment’s offering documents because it will help them build their own proforma estimate of how much they could expect to receive from the investment versus how much the private equity firm/private equity fund will receive for their stewardship of the deal.
Using The Hurdle Rate In Commercial Real Estate Investments
From an individual investor standpoint, it is important to note that hurdle rate(s) (there can be more than one) are set by the private equity firm. In doing so, they must balance the compensation that they need to earn to meet their own return objectives and the return objectives of the investors in their deal. In addition, the private equity firm must balance the hurdle rate structure with market dynamics because there are many private equity firms vying for investor capital and some may be willing to take a lower return for more capital.
It can’t be stressed enough that this structure is outlined in the investment’s offering documents, and investors must read and understand it to ensure they are comfortable with it.
Drawbacks of a Hurdle Rate in Private Equity
In a waterfall structure, individual investors face two drawbacks with regard to the hurdle rate(s).
First, the hurdle rate is defined by the private equity firm or deal leader (sometimes they could be a venture capital fund or pension fund) on a deal by deal basis or at the fund level. Again, the firm must balance fairness and competition in doing so, but investors do not have any input on this decision.
Second is that the hurdle rate calculation methodology can be manipulated, which could potentially result in a more favorable share of the profit for the private equity firm. For this reason, investors must ensure that they are working with a fund manager/private equity firm that has a long track record of equitable distributions and should take the time to follow the calculations outlined in the offering documents to ensure they are in agreement with them.
Benefits of Investing Through Private Equity Real Estate
Finding, buying, and managing institutional grade commercial assets can be incredibly time consuming, resource intensive, and it can require a significant amount of experience to do it correctly. For this reason, direct property ownership may not be the most suitable option for some individual investors looking to gain exposure to commercial property assets.
Fortunately, a partnership with a private equity firm can be a profitable alternative. In return for giving up a small share of the potential profit (sometimes referred to as carried interest, incentive fees or performance fees), individual investors can gain exposure to top quality assets and leave all of the hard work of finding, buying, and managing them up to the private equity firm. When done correctly and equitably, this arrangement can provide a healthy return for both parties.
Summary & Conclusion
- A hurdle rate in private equity is a point at which the cash flow split between a private equity firm and their investors changes.
- Hurdle rate(s) are particularly prevalent in private equity transactions that contain a distribution waterfall (it could be an American waterfall or a European waterfall).
- Although unique to each deal, hurdle rates are usually measured using either the Internal Rate of Return (IRR) or the equity multiple. The details are described in the investment’s offering documents.
- For individual investors, there are two key drawbacks to the hurdle rate(s). The first is that they are created by the private equity firm so the investor doesn’t necessarily have any say in them. In addition, the calculation of the rates can be skewed in favor of the deal leader.
- For individual investors, it is critically important to read and understand every investment’s offering documents to ensure they are comfortable with them.
- Finding, financing, and managing a commercial property asset can be incredibly time consuming and resource intensive for individual investors. For this reason, it may be more suitable to partner with a private equity firm to make a commercial real estate investment.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
