A hurdle rate is the minimum return necessary for a fund manager to start collecting incentive fees. The hurdle is usually tied to a benchmark rate such as Libor (London Interbank Offered Rate) or the one-year Treasury bill rate plus a spread.
Hedge funds which specify a soft hurdle rate charge a performance fee based on the entire annualized return. Funds which use a hard hurdle rate only charge a performance fee on returns above the hurdle rate.
Let’s say, for example, a hedge fund manager sets a hurdle rate at 5%, which is a standard annual rate. If the fund garners a 50% return in one year, the manager will only collect performance fees for 45% of that gain.
Though logically appealing, this practice has diminished as demand for hedge funds has outstripped supply and hurdles are now rare.
Hedge funds usually employ a high water mark, sometimes by itself, and sometimes in conjunction with a hurdle rate.