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| Hurdle Rate |
A hurdle rate is, in general, the minimum rate of return of an investment so that certain events take place. In particular, the minimum (expected) rate of return so that an investment is realized at all is called a hurdle rate.
Such hurdle rates are identical to costs of capital and enter quantitative capital budgeting decision problems. Corresponding adequate hurdle rates can be derived from formal capital market models like the capital asset pricing model.
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Moreover, in the private equity and venture capital industry, hurdle rates stand for minimum rates of return for external investors that have to be met, before the management of a private equity or venture capital company receives a bonus payment (called “carried interest”).
The appropriate choice of such kinds of hurdle rates is the object of the agency theory that analyzes the possible incentive effects of different kinds of contractual designs. The implementation of hurdle rates leads to a specific class of incentive contracts that is denoted as piecewise linear with a kink or a jump discontinuity at the point where the hurdle rate is met.
