Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

In what condition might a soft hurdle rate be beneficial for fund managers?

1. When aiming for high risk-adjusted returns

2. When all profits can earn incentive fees

3. When profit margins are under pressure

4. When investor expectations are low

The correct answer is: When all profits can earn incentive fees

A soft hurdle rate can be beneficial for fund managers primarily when all profits can earn incentive fees. This is because a soft hurdle rate allows fund managers to start earning performance fees on all profits above a specified threshold, rather than just on profits that exceed that hurdle. This structure can incentivize managers to pursue a broader range of investment opportunities and attract capital during periods when higher performance might be harder to achieve. In situations where the performance of investments is moderate or returns are difficult to achieve consistently, being able to earn fees on all profits can maintain alignment between the interests of the manager and those of the investors. It encourages fund managers to take action and generate returns as opposed to simply meeting a strict performance benchmark that might be challenging during certain market environments. Consequently, this framework can foster a collaborative relationship; managers are rewarded for any performance they deliver, which can be particularly motivating when investors are more focused on capital preservation or when market conditions are subdued.