A Hurdle Too High

Cowardly Lion says, "My hurdle rate is 15%, what's yours?"We had friends over for dinner on Saturday. One of the guys is a former senior General Electric exec, who now keeps busy with a variety of venture capital activities. He’s involved in developing a major server farm project out West. With plans and permits in hand, he’s leading the group pitching the project to investors, looking for the money to build the project, then ultimately sell it and return profits to both the investors and his venture group.

What he is finding is interesting. Nobody is willing to seriously discuss committing funds at a hurdle rate of less than 15%. “Hurdle rate” is an investor’s way of expressing his minimum return requirement, at least in theory.

The reality is that setting a hurdle rate of 15%, when risk-free assets are yielding less than one-half of one percent, is really just using B-school lingo to avoid doing any deal, without admitting that you are simply too scared to make any risk-oriented investment; it is a way of pretending to be in the game when you are really too timid to leave the sidelines.

We have learned a great deal about risk-tolerance over the last decade or two.  In particular, we now recognize that risk tolerance is a very slippery concept. In good markets, individuals are absolutely terrible at estimating their tolerance for risk in bad markets, and vice versa. The self-identified high-risk speculator with the NASDAQ at 5,000 turns out to be a cowardly cash-hoarder with the NASDAQ at 1,200. Not only is risk tolerance highly variable in the same individual over time, it can change sharply over short periods and it is systematically inversely-related to actual investment opportunity.

The investment press is full of nightmare scenarios, driven by crashing French banks, soaring budget deficits or double-dip recessions.  Few observers are constructing optimistic scenarios.  Given a run of good news, from pretty much any quarter, I suspect those fantasy hurdle rates of 15% may suddenly correct to 8%, in which case a huge amount of money could find its way into the stock market — and into the type of private equity transaction my friend is pitching.

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2 thoughts on “A Hurdle Too High

  1. I think it means they don’t BELIEVE the claimed return on investment is true. Maybe this is just another interpretation for risk. Obviously if I BELIEVED 5% with other stuff I was already doing was 3%, I would do it, but a PRETEND 15% might not be attractive.

    Is there a study showing actual returns compared to the returns claimed when soliciting investors? That would be a fun graph to look at. I would guess zero correlation between the return claimed and the return achieved.

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    • No, I really don’t agree. Doing this kind of deal is in large part a function of price. Whatever the total economic return, it is on the buy side that you essentially determine how much each partner gets. At a 15% return, there is really nothing left for the seller/organizer of the transaction.

      There is certainly a considerable amount of puffery in the promotion of investment deals, but much less as you get into the serious-investor space where half-billion dollar deals get done. To take an obvious example, I suspect that Warren Buffett, in evaluating a possible purchase for Berkshire Hathaway, is able to make return calculations that are not entirely unrelated (as you suggest) to subsequent performance. Certainly, on Buffett’s purchase of Burlington Northern, there were many other professional investors who suggested that Buffett had paid too much, and that subsequent returns would be sub-par by Berkshire’s lofty standards.

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