Hurdle rate

The term represents the minimum required return on an investment for it to be deemed profitable for investment purposes. 

The hurdle rate sets the baseline return that a project or investment must attain to meet a predefined criteria for approval by the manager or investor. It serves as a critical tool for companies in assessing the profitability of pursuing a particular project. This rate is determined by considering the appropriate compensation for the estimated level of risk; projects with higher levels of risk typically entail higher hurdle rates compared to those with lower risk profiles.

This term frequently finds application in private equity investing and hedge fund management. In a private equity investment fund, for instance, the General Partner is eligible to levy performance fees, commonly referred to as carried interest, only when the Limited Partner’s rate of return matches or surpasses the hurdle rate – an established minimum acceptable rate.

Calculating the hurdle rate

In order to calculate the hurdle rate, investors use the following formula:

Hurdle Rate = Weighted Average Cost of Capital + Risk Premium

Hurdle rates are very important for businesses, particularly in evaluating upcoming ventures and initiatives. Companies assess the viability of engaging in a capital project based on its associated risk level.

When the anticipated rate of return surpasses the hurdle rate, the investment is deemed viable. However, if the rate of return falls below this threshold, management may opt not to proceed. Additionally, a hurdle rate is alternatively known as a break-even yield.