What is an IRR Hurdle?
An IRR Hurdle is a provision of a waterfall structure. It acts as a mechanism to incentivize sponsors to outperform by offering an increasingly larger portion of the profits to investors as specific return thresholds are met.
An IRR hurdle is essentially a way for sponsors to share in the risk and reward of the investment with their investors through a series of hurdles that the investment must achieve for the sponsor to be rewarded with a higher ratio of profits. These hurdles are typically set as a specific internal rate of return (IRR) threshold (also referred to as a hurdle) that the investment must achieve before the sponsor can receive a higher proportion of the profits.
IRR Hurdle Examples
The first typical IRR hurdle, known as the preferred return, might be set at 8%, meaning that the investment must achieve an 8% IRR before the sponsor can receive a share of the profits.
Another example of a hurdle could be what is called an IRR flip, meaning that the split may be 80/20 until an IRR of 18% is met. Once that hurdle is met, the split flips to 20/80 for everything above, providing an upside for the sponsors if they perform really well on the project.
Benefits of IRR Hurdles
The purpose of IRR hurdles is to encourage sponsors to focus on achieving a higher return on investment by providing them with a higher profit share as specific return thresholds are met.
Benefits IRR hurdles can include:
- Promoting a sense of healthy competition among sponsors, who may be motivated to outperform their peers by achieving a higher IRR.
- Sponsors may be more likely to take calculated risks and pursue innovative strategies to achieve higher returns, which can benefit the overall performance of the investment.
- Helping to align the interests of the sponsor and the investors, as both parties are incentivized to work together to achieve the same goal.
IRR hurdles can be perceived as controversial because investors perceive the change in the split as the sponsor biting into their returns. However, the argument for IRR hurdles is that they provide sponsors with the incentive to deliver the best possible product and mitigate costs to reach those returns.