Hurdle Rates for PE/VC Funds: An Overview

Craig Hart, Contributing Editor to VC Experts, Inc.

A hurdle rate is a provision that requires that the partners recover their capital contributions and, often, a specified rate of return, before the general partner starts receiving its allocation and distribution of profits in respect of its carried interest. The justification for the hurdle provision is that the general partner should not earn its carried interest until the partners who provided the capital to the partnership are repaid their investment and earn a return on their investment. This Note addresses commonly negotiated issues in drafting hurdle provisions, the incentives created for the general partner, and basic tax aspects of hurdle provisions.

Example Hurdle Provision

A typical hurdle rate provision is set out below - the example requires that the partners receive their capital contributions plus an 8% return thereon before any profits are distributed to the general partner in respect of its carried interest. In some partnerships, only the limited partners make capital contributions and therefore receive distributions prior to the general partner meeting the hurdle. If the general partner makes a capital contribution, which is usually no more than 1% of all capital contributions, then the general partner may (or may not) participate in distributions prior to meeting the hurdle to the extent of such contribution. In our example, the general partner receives distributions to the extent it made capital contributions. In the example provision, once the hurdle is met, profits are thereafter allocated to the general partner on its carried interest until the overall allocation of profits, after repayment of the partners' capital contributions and return thereon, is 80% to the partners in proportion to their capital contributions and 20% to the general partner in respect of its carried interest; thereafter, profits are divided in the same 80/20 proportion between the partners contributing capital to the partnership and the general partner, respectively.[1]

The example provision is as follows with bracketed language showing commonly negotiated points:

Items of Partnership income shall be allocated (i) to the Partners [in proportion to their relative capital contributions] until such time as an immediate distribution to each Partner of the [amount of such Partner's Capital Account balance, and taking into account prior distributions,] would result in such Partner achieving a pre-tax internal rate of return on such Partner's actual capital contributions of [eight percent (8%)] per annum, based upon annual compounding, a 360-day year of 12, 30-day months [and no compounding for periods of less than one full year,] (ii) secondly, [solely to the General Partner] until the cumulative amount of all income allocated to the General Partner, ignoring income allocated to the General Partner by virtue of its contributed capital, is equal to [20%] of the cumulative amount of income allocated to all Partners, and (iii) thereafter, [20%] to the General Partner and [80%] among all Partners in proportion to their respective capital contributions.]

The hurdle in the above example is calculated as follows: for a $10 million capital contribution made by a partner, that partner's hurdle will be set at $10.8 million in the first year - the succeeding year, assuming no further capital contributions are made by that partner, the hurdle increases by an amount equal to 8% of $10.8 million totaling $11.66 million in the second year. If additional capital contributions are made at the beginning of the second year, then an additional amount equal to the additional capital contribution plus 10% thereon, is added to the total hurdle for that partner. Likewise, if distributions are made at the end of the first year to partners who made capital contributions, these distributions are subtracted from the hurdle amount. After the hurdle is met, then the partners making capital contributions and the general partner are allocated profits according to their agreed allocation, in our example an 80/20 allocation, often with a "catch-up" provision in favor of the general partner, as described below. [For ease of application, the example does not provide for any adjustment for mid-year contributions and distributions, however, this may be a negotiated point].

Negotiated Issues

The following issues are commonly negotiated in hurdle provisions:

Prior to meeting the hurdle, the percentage of capital contribution that must be returned to partners who are obligated to make capital contributions to the partnership before the general partner may receive distributions in respect of its carried interest. The rate of return, if any, to be paid on such capital contributions, and whether the rate is to be applied to capital commitments or actual capital contributions. After the meeting hurdle, the percentage of profits allocated among the partners who are obligated to make capital contributions to the partnership and the general partner in respect of its carried interest. A recapture or "clawback" provision on distributions to the general partner.

The allocation of profit between the partners prior to meeting the hurdle rate is a negotiated point. A number of approaches favor the limited partners by delaying distributions of the carried interest to the general partner before the return of capital contributions to all partners. These approaches include: allocating 100% of distributions in favor of the limited partners and 0% to the general partner (reflecting the most rapid allocation in favor of the limited partners), allocating distributions based on the relative capital contributions of the partners (for example, if the limited partners contribute 99% and the general partner contributes 1% of capital to the partnership, then this would also be the percentage distribution of profits prior to meeting the hurdle), or allocating distributions based on relative bargaining power (such as 90% to the limited partners and 10% to the general partner). In our example provision, the allocation prior to meeting the hurdle is based on the relative capital contributions of the partners (in our case, 99%/1%). Additional issues include whether the amount of contributed capital to be returned includes contributed capital used to fund management fees and other operating expenses in addition to investments (the most common and the approach employed in the above model) or the amount simply requires return of contributed capital used to fund investments not including capital used to fund management fees and expenses.

If the distribution of carried interest to the general partner is delayed to repay the capital contributions of the other partners, then after meeting the hurdle rate, the general partner often receives accelerated distributions of profits until it has received its carried interest on the distributions made to the other partners - this is commonly known as a "catch-up provision". In our example, after meeting the hurdle, 100% of profits are allocated to the general partner until profits are distributed on a 80/20 allocation between the partners making capital contributions and the general partner. Although a 100% recapture rate is the norm, a less rapid catch up provision ranging from 80% to as low as 50% of all distributions is not unusual. The lower the percentage of the catch-up rate, the higher the hurdle rate effectively becomes. For example, with a 100% catch-up rate and a 8% preferred return, the effective hurdle rate is 10%; by comparison, with a 80% catch-up and a 8% preferred hurdle, the effective hurdle rate is 13.3%.

An alternative approach that has become increasingly common is to distribute the total carried interest to the general partner (the full 20% in our example) on a deal-by-deal basis even if the partners making capital contributions have not received the return of their capital contributions. The economic rationale for making distributions of carried interests on a deal-by-deal basis is that it gives the general partner proper economic incentives to make appropriate fund investments according to the stated objectives of the fund, rather than the incentive structure under the delayed distribution of carried interest approach that incents the general partner to seek rapid repayment of capital contributions as soon as possible so that the general partner may begin to receive distributions of its carried interest. The approach also significantly improves the IRR of the general partner at the expense of the limited partners.

If the deal-by-deal approach is adopted, any payout to a general partner in advance of repaying capital contributions should be subject to a contractual recapture or "clawback" provision because the general partner is receiving distributions in anticipation of the partnership earning sufficient profits to repay the capital contributions of all the partners. The various issues in drafting a clawback include the amounts to be returned by the general partner in the event the clawback provision is triggered, the escrow of all or a portion of distributions of carried interests prior to meeting the hurdle as a means to collateralize the general partner's potential obligations under clawback provisions, the terms of releasing funds from escrow to the general partner (such as the fund achieving some target value), and fund valuation, all of which are described more fully in 10.1.8.a: Note on Contractual Clawback.

Another issue is whether a specified rate of return is to be paid on either the amount of the partner's commitment to make capital contributions or the amount of the capital contributions actually made to the partnership. In the above example, the rate of return is 8% of the actual capital contribution. Some partnership agreements apply higher rates to actual capital contributions and lower rates to uncalled capital commitments, the latter rate being similar to a commitment fee in a bank lending arrangement. In our example, there is no such concept of a "commitment fee".

The negotiated points discussed in this Note impact the internal rate of return ("IRR") of the limited partners and general partner because these provisions affect the amounts and timing of payments among the partners and the partnership. For a discussion of how these provisions affect the IRR of the partners, see 10.6.3: Note on Impact of Hurdle Rates and Management Fee on IRR of the Partners.

Incentives Structure of General Partner under Hurdle Provision

As noted above, the inclusion of a hurdle provision affects the incentives of a general partner with respect to the management of the partnership, particularly in the areas of investment strategy and in-kind distributions. Hurdle provisions have been criticized because they incent the general partner to pursue short-term returns in order to achieve the hurdle rate so that the partnership can commence making distributions to the general partner on its carried interest.[2] One way to partially mitigate this risk is to treat differently returns from investments in venture companies and returns from short-term investments of contributed capital awaiting investment in a venture company. The returns on short-term or "idle funds" investments typically do not count toward meeting the hurdle rate and are either allocated entirely to the limited partners or allocated to the partners in proportion to their capital contributions. Although such a provision may not eliminate the general partner's incentive to favor safer short-term investments in all cases, it will prevent the general partner from earning its carried interest or any return from investing in money market type investments.

Incentive issues also arise in the area of in-kind distributions of securities by the fund. In-kind distributions of securities are an important aspect of venture capital funds because the partnership can make distributions of marketable securities having unrealized gains or losses on a tax-free basis to the partnership and its partners. Hurdle provisions create an incentive for the general partner to attempt to satisfy the hurdle by distributing securities that have inflated values or that are expected to decline in value, and to retain in the partnership those securities that have greater appreciation potential for distribution after meeting the hurdle. In order to mitigate the incentive of the general partner to manipulate the timing of distributions of securities in this way, valuation procedures are essential to prevent abuse. Provisions governing valuations should be drafted into the partnership agreement to protect limited partners. See 10.1.6.c: Note on Valuation of Illiquid Securities. One common approach is that prior to the fund's liquidation, in-kind distributions are limited to securities that are publicly traded and are valued at the publicly quoted trading price on the date of distribution.

Provisions in the partnership agreement requiring that a specified percentage of profits must be distributed in the year that they are earned impacts the application of the hurdle provision and implicate the incentives of both limited partners and general partners. General partners often want to retain profits to maintain greater flexibility and to increase fees in cases where commissions are based on the amount of funds under management, whereas limited partners often want their returns immediately. Distributions are typically made in an amount sufficient to provide cash to pay the tax obligations of the partners.

Tax Considerations

Although tax issues are not addressed fully here, it is important to note that the hurdle provision presents various tax considerations for the general partner, the limited partners and the partnership. For the general partner, the issues are the timing of any taxes on the general partner's carried interest and the characterization of its receipt and any distributions thereon as ordinary income or long-term capital gain. In turn, this effects the tax deductions available to the partnership to be passed through to its partners. These issues turn on whether the general partner's carried interest represents a partnership interest or can be recharacterized as compensation for managing the fund in the form of a transfer of partnership capital, taxable as ordinary income to the general partner upon receipt and giving rise to a deduction to the partnership. If the general partner were entitled to receive proceeds of partnership assets if the partnership were to liquidate immediately after formation, the carried interest of the general partner may be construed to be a transfer of partnership capital to the general partner that would be taxable upon its receipt as ordinary income. A properly drafted hurdle provision prevents this adverse tax treatment for the general partner by preventing distributions to a general partner in the event of liquidation of the fund immediately after its formation.

[1] The 80/20 split has the advantage of long standing usage. Some of the more celebrated funds are obtaining larger carried interests, benefiting from a 'flight to quality' presumably. Some recent data indicate 16 funds, Accel, Greylock, Battery, Oak, etc. have negotiated for a 25-30 percent carried interest post March 2000, almost all of which are at least the fifth iteration of the initial fund. See Insider, May 30, 2001.

[2] See Dauchy & Harmon, Structuring Venture Capital Limited Partnerships, 3 Computer Law.I (1986).