Investors and Hedge Funds Are Quarreling: Should the Risk-Free Rate Heighten Their Hurdle?

A fundamental conflict has emerged between institutional investors and hedge fund managers over whether rising interest rates should reset performance hurdle rates—the minimum return threshold required before managers can claim performance fees. With the risk-free rate now hovering around 4.5% (measured by Treasury yields), investors argue that hedge funds should adjust their hurdles upward to reflect this elevated baseline, preventing managers from collecting performance fees on returns that merely track risk-free instruments.

According to a BNP Paribas survey of 84 institutional investors and hedge fund managers, the disparity in views is stark. Ninety percent of investors support raising hurdle rates in line with the risk-free rate or a relevant benchmark, reflecting the principle that they should not pay 20% performance fees on returns that could be earned passively. However, only 42% of hedge fund managers have agreed to this adjustment, creating a fundamental negotiation standoff. The BNP Paribas analysis suggests that the 52% of managers opposing hurdle rate adjustments believe such changes do not suit their specific strategies, though only 6% explicitly stated that hurdle adjustments should be strategy-dependent.

The practical mechanics of this debate are particularly acute for certain hedge fund strategies. Managed futures funds, for instance, hold cash collateral against their trading positions and currently earn 4-5% annually on that collateral before executing any trades. This dynamic artificially lowers the bar for crossing the hurdle and triggering performance fees—a structural advantage that investors view as unjustifiable. The fundamental investor rationale is transparent: why pay performance fees on returns generated by risk-free positioning rather than genuine alpha generation?

The broader context underscores the urgency of this conversation. Marc Lasry, CEO and co-founder of Avenue Capital Group, warned in January 2023 that higher interest rates would fundamentally transform hedge fund economics. That prediction is now crystallizing in practice as investors leverage their negotiating power to challenge traditional fee arrangements. Notably, only 27% of hedge funds currently employ hurdle rates at all, and this figure has not increased materially despite rising rate environments, suggesting entrenched resistance to fee restructuring even as investor pressure mounts.