Term of Focus - Hurdle Rate

Hedge fund

A private investment vehicle whose manager receives a significant portion of its compensation from incentive fees tied to the fund's performance -- typically 20% of annual gains over a certain hurdle rate, along with a management fee equal to 1% of assets. The funds, often organized as limited partnerships, typically invest on behalf of high-net-worth individuals and institutions. Their primary objective is often to preserve investors'capital by taking positions whose returns are not closely correlated to those of the broader financial markets. Such vehicles may employ leverage, short sales, a variety of derivatives and other hedging techniques to reduce risk and increase returns. The classic hedge-fund concept, a long/short investment strategy sometimes referred to as the Jones Model, was developed by Alfred Winslow Jones in 1949.

High-water mark

A provision serving to ensure that a fund manager only collects incentive fees on the highest net asset value previously attained at the end of any prior fiscal year -- or gains representing actual profits for each investor. For example, if the value of an investor's contribution falls to, say, $750,000 from $1 million during the first year, and then rises to $1.25 million during the second year, the manager would only collect incentive fees from that investor on the $250,000 that represented actual profits in year-two.

Hurdle rate

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 or the one-year Treasury bill rate plus a spread. If, for example, the manager sets a hurdle rate equal to 5%, and the fund returns 15%, incentive fees would only apply to the 10% above the hurdle rate.