Private credit funds have been reaping substantial profits lately due to the surge in interest rates. However, investors are beginning to discuss whether fund managers deserve such substantial windfalls.
Firms operating in this thriving $1.5 trillion market typically offer loans at variable interest rates, allowing fund managers to enjoy higher yields from borrowers as base rates rise. This enables funds to surpass their "hurdle rates," the threshold at which they can begin collecting profits, also known as "carry," on their returns.
Now, many investors, known as limited partners (LPs), are seeking greater flexibility in how the carry is calculated. They are exploring whether it makes sense for fund managers to earn significant rewards solely because central banks are increasing rates.
"In recent months, LPs have generally been showing more attention to the details of any position they take," says David Bouchoucha, head of private debt and real assets at BNP Paribas Asset Management. "Examining the hurdle rate and its alignment with the base rate is part of it."
Private credit firms typically set their hurdle rates between 5% and 7%. When a fund's returns reach that threshold, managers can share in the profit, in addition to the 1%-2% management fees collected throughout the fund's life. Managers often receive around 10%-15% of the returns once they've crossed the hurdle, which can reduce the profit for investors.
The discussions around the current situation reflect investors' growing influence in a private credit industry flooded with new funds, making them more selective when choosing where to invest their capital. This trend is making it harder for smaller credit firms to compete.
To address investor demands for flexibility, one popular option is to link hurdles to central bank rates, causing them to rise or fall in line with monetary policy.
"Returns are really dependent on the base rate," says Florian Hofer, director for private debt at Golding Capital Partners. "I think there's a fair alignment of interest between the funds and the LPs for this." Funds are "concerned that if base rates go down again they'll lose their carry, so I think a floating hurdle rate is a fair compromise," he adds.
Christian Wiehenkamp, chief investment officer at Perpetual Investors, manages a fund that invests in private credit funds and has employed a hurdle rate tied to base rates since 2021. He believes it's right to reward funds for their performance rather than simply rate hikes: "We need to earn cash plus something to show we're generating alpha that you wouldn't get elsewhere."
Investment firm Muzinich & Co. is also offering floating rate hurdles for those interested. "There's a general sense that investors are exploring alternative approaches," says Kirsten Bode, its cohead of pan-European private debt.
However, some managers argue that pegging hurdles to base rates may not fully compensate funds for the additional risk in a challenging macroeconomic environment, especially during a recession with more corporate defaults and bad loans.
Floating rate hurdles can also add complexity to fund administration and capital distribution. "Overengineering floating rates can provide difficulties," says Luis Mayans, partner and deputy head for private debt at CDPQ.
Philip Edmans, who leads the capital markets team at Inflexion Private Equity Partners LLP, acknowledges that there's much debate about whether hurdle rates for debt funds will become floating, but he believes that "spread tightening is probably more likely." As private credit firms have been charging substantial premiums, or the "spread" over base rates, on loans to companies, Edmans expects they'll have to reduce these premiums during tougher times for borrowers. If yields decline, funds may not need to adjust hurdle rates.
A new report from law firm Macfarlanes LLP reveals that some managers are simply raising their hurdle rates, typically by less than 100 basis points. Other funds are choosing to modify the so-called "catch-up" period, effectively postponing some of the retrospective profit share they're entitled to from investors once the hurdle rate is exceeded.
Overall, the discussions surrounding hurdle rates reflect LPs' willingness to actively engage with their funds, especially smaller ones. While fundraising in private credit has generally remained resilient, investor preference for larger, more established firms is putting sub-$5 billion outfits in a challenging position.
Investment Disclaimer: This article is for informational purposes only and does not constitute investment advice or a recommendation regarding private credit funds or any investment. Before making investment decisions, individuals should conduct their own research and consider seeking professional advice. Investing in private credit funds carries risks, and past performance is not indicative of future results.