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Private equity's 'potential crisis'

March 5, 2013: 12:33 PM ET

hudlersDo private equity firms need to make a structural change?

FORTUNE -- Private equity funds have long featured "hurdle rates," or preferred returns that funds must generate for investors before fund managers get to begin sharing in the profits (i.e., carried interest). But one senior private equity executive believes that current hurdle rates pose "a potential crisis" for the industry.

Jeremy Coller, founder and chief investment officer of Coller Capital, made the comments last week during the SuperReturns International conference in Berlin, Germany.

Coller's primary concern was that hurdle rates have become divorced from their original purpose -- compensation for extra investor risk inherent in a long-term, illiquid asset class like private equity. For example, hurdle rates originally were set at around 8%, because that is what investors would have been able to get were they to instead put their money in 10-year U.S. Treasuries.

The result, Coller argued, is a misalignment of interests that has artificially elongated the time fund managers must wait before receiving carried interest (if they receive it at all). Particularly given that nearly half of the conference attendees said they expect private equity returns to be between 5% and 10% during the next cycle.

This may not matter much at the senior levels, Coller said, but eventually could cause fewer young professionals to enter the industry. It also could cause some existing junior staffers to seek out other opportunities that are closer to the carry -- disruptions that ultimately could affect returns at the funds they leave behind.

To be clear, there is no indication that limited partners in private equity funds have any interest in lowering hurdle rates. And there certainly is a case to be made that if a PE fund manager can't generate in excess of 15% or 20%, then they really aren't doing their job. But it's worth noting that this is an issue that clearly is weighing on the industry's mind, particularly as rates remain low.

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Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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