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CFA Level I · CFA Level I Exam · Hedge Funds

A hedge fund's incentive fee is 20% of profits above a 5% hard hurdle rate. The fund earns a gross return of 12% before incentive fees, and management fees are ignored. Compared with a soft hurdle of 5%, the hard hurdle most likely results in an incentive fee that is:

The hard hurdle gives a lower incentive fee. It charges 20% only on the 7% above the hurdle, equal to 1.4%, while a soft hurdle charges 20% on the full 12% once the hurdle is cleared, equal to 2.4%.

  1. Alower, because the fee applies only to the excess over 5%Correct
  2. Bhigher, because the fee applies to the entire 12% return
  3. Cthe same, because both hurdles produce identical fees at 12%

Explanation

With a hard hurdle, the fee is charged only on returns above the hurdle: 20% x (12% - 5%) = 1.4%. With a soft hurdle, once the hurdle is exceeded the fee applies to the whole return: 20% x 12% = 2.4%. The hard hurdle therefore gives the lower fee.

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