Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

What differentiates a hard hurdle rate from a soft hurdle rate in terms of incentive fees?

1. Both allow incentive fees at the same threshold

2. Hard hurdle allows fees only on profits above the hurdle

3. Soft hurdle restricts fees to profits below the hurdle

4. Hard hurdle applies only to loss-making funds

The correct answer is: Hard hurdle allows fees only on profits above the hurdle

A hard hurdle rate is characterized by the stipulation that incentive fees can only be charged on profits that exceed a specified threshold. This means that if the fund does not surpass the hurdle rate, no incentive fees are paid to the fund manager. Therefore, the rewards for the fund manager are directly linked to their ability to generate returns above that specific rate, ensuring that the manager is incentivized to achieve superior performance for the investors. In contrast, a soft hurdle rate allows for incentive fees to be charged even if only a portion of the returns exceeds the hurdle. This means that if the fund returns exceed the hurdle rate, the manager can collect fees on the entire profit, not just the amount above the hurdle. Understanding these concepts helps emphasize the different ways these rates affect the alignment of interests between fund managers and investors, particularly regarding performance incentives.