Many asset managers selling direct lending investment vehicles have made moves to lower hurdle rates in the latest round of fundraising, which would effectively increase their overall fees, according to consultancy bfinance.

Niels Bodenheim, London-based senior director of private markets at bfinance, and Dharmy Rai, associate within bfinance’s private markets department, said: “Some are sounding out the idea; some have already tried to market their latest offerings; most have not (yet) succeeded in taking a step that, for [limited partners (LPs)], would be hard to stomach.”

Hurdle rates are the point at which lucrative “catch-ups” and performance fees kick in, the firm explained.

In a market commenary, Bodenheim and Rai said that, often, the height of a hurdle and the structure that kicks in when it is reached receive less attention than management fee and carry percentages.

This may be because the latter are often open to negotiation while the former are set in fund terms and conditions, they said.

“Yet the hurdle is, arguably, the most important part of the fee leakage puzzle,” they said.

“Indeed, we see examples where managers with lower management fees end up taking home more money purely because they reached the same — net-of-management-fee — hurdles sooner than they otherwise would have done,” said Bodenheim and Rai.

The pair said they did not believe direct lending managers’ hurdle rates had been too high in recent years and that in some cases, the threshold had already been a bit too low.

“There is still, on average, too much leakage in the net performance figures,” they said, adding that in general the hurdle should be no lower than 2% beneath the fund’s expected return.

Although it might be understandable that firms were cutting hurdle rates if expected returns were lower for new funds — in order to keep their business profitable — bfinance said that this did not seem to be the case –– expected returns on funds being raised in 2017 were broadly the same as before, except where strategies were very different.

One explanation could stem from the fact that many private debt funds were run by private equity firms, said Bodenheim and Rai. Staff at these companies expected the same compensation that they received for private equity work.

But this was hard to justify, bfinance said, since private equity managers could generate significant upside but private debt managers could not.

Following noticeable improvement for LPs in management and performance fees for direct lending funds over the last few years, a reduction in hurdle rates could represent a backwards step, Bodenheim and Rai said.

“Hopefully the negative reaction among investors, together with rising competition among fund managers, will dissuade firms from following through on such changes,” they said.

 

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