How does the discount rate for the IRR hurdle play out in different market phases?
The IRR hurdle (typically 8%) is set in absolute terms, but its relative value depends on the market phase.
In low-rate periods (2010–2018) with a risk-free rate of 0.5–2%, an 8% hurdle is a wide spread (6–7.5 ppt over the RFR) — hard to beat. In the current higher-rate phase with a 2.5% RFR, the spread narrows to 5.5 ppt — the 8% is relatively easier to reach. That's why in high-rate phases LPs often negotiate for a 10–12% hurdle.
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| Period | 10Y govt bond | 8% hurdle = spread |
|---|---|---|
| 2010–2018 (low rate) | 0.5–2% | 6–7.5 ppt |
| 2018–2021 (negative rate) | −0.5 to 0% | 8–8.5 ppt |
| 2024 | 2.5% | 5.5 ppt |
| Hypothetical 2025 (5% RFR) | 5% | 3 ppt |
| Market phase | Sponsor strategy |
|---|---|
| Low rate (hurdle relatively high) | more aggressive leverage, higher IRR targets |
| High rate (hurdle relatively low) | more conservative leverage, lower absolute IRRs acceptable |
- A sponsor pitches "20% IRR" in a high-rate phase without showing the context that it's only 5 ppt over the RFR: LPs react skeptically.
- Forgetting that the "hurdle rate" is fixed: it should be reviewed against the market phase in the fundraise.
Question: "Why an 8% hurdle in a high-rate phase?"
Answer: "It's the PE standard — grown historically, not inflation-indexed. In high-rate phases LPs often negotiate for 10%, but 8% remains the industry default. In low-rate phases the sponsor benefits — the 8% hurdle looks more demanding than it is in absolute terms"