What's the difference between a soft hurdle and a hard hurdle rate?

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AcadiFi · Accepted Answer

A hurdle rate is a minimum return the fund must deliver before the manager earns any incentive fee. The 'soft vs hard' distinction is about WHAT the incentive fee applies to once the hurdle is cleared.

Hard hurdle: Incentive fee applies ONLY to returns in excess of the hurdle. If the hurdle is 8% and the fund returns 14%, the incentive fee is 20% × 6% = 1.2%. The manager forever loses the fee on the first 8%.

Soft hurdle: Once the hurdle is cleared, incentive fee applies to the ENTIRE return (all of it, including the portion below the hurdle). If the hurdle is 8% and the fund returns 14%, incentive fee = 20% × 14% = 2.8%. If the fund returns 7.99%, incentive fee is zero.

Whoxcomb Arbitrage uses 8% soft hurdle + 20% incentive. Year A: fund returns 7.8%. Manager gets nothing. Year B: fund returns 14%. Manager gets 20% × 14% = 2.8% of NAV. Hardeway Event-Driven, same 8% hurdle but HARD: Year B manager only gets 20% × (14% − 8%) = 1.2%.

Many LPAs add a 'catch-up' provision: once the hurdle is cleared, the manager gets 100% of the next few percent of returns until the effective fee catches up to the 20% level that would have applied without a hurdle. This is very common in private equity but rare in hedge funds.

Hurdles can be fixed (e.g., 8%) or floating (e.g., T-bill + 3%). Floating hurdles are fairer in rising-rate environments — otherwise an 8% hurdle looks easy when rates are 7%.

Investors should always determine which hurdle type is specified because the difference is material: on a 12% fund return with 5% hurdle, hard vs soft changes the fee from 1.4% to 2.4% of NAV.

What's the difference between a soft hurdle and a hard hurdle rate?

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