What are hurdle rates in mergers & acquisitions? And how are they determined? Are there differences for different type of acquirers, e.g. corporate/strategic acquirers vs. financial investors such as private equity (PE)?
Although determining hurdle rate for an investment is not a straight forward thing as it depends on many subjective assumptions, in theory it should not be too hard to determine as it is composed of the following factors: cost of capital, risks involved, rates of return for similar investments, current business expansion opportunities, and other factors that could directly affect an investment. The general rule is that hurdle rate should not be less than internal rate of return for an investment.
However, question is how come hurdle rates have not come down since the beginning of the global financial crisis following the decrease in cost of capital? I think this is one of the fundamental questions of modern era valuation. It seems profitability thresholds for companies have increased in the meantime as the difference between hurdle rates and cost of capital are historically high. This implies management’s risk perception to be very high and I am not certain these risks are well reflected in today’s valuations.
Hurdle rate can also be understood as ‘Opportunity cost’. If I have usd 100 and the best way I can invest is stock market at 17% IRR, then this becomes my hurdle rate to alternatively invest somewhere else. Any company trying to get this USD 100 from me needs to convince me that I can get more than 17% by investing in them.
Similarly, a Company needs to define its hurdle rate or minimum return reqd by investing a project. For an entrepreneur, a hurdle rate is the salary he is earning while working as an employee in a firm. He needs to earn more than this hurdle rate to justify his existence ( financially) as an entrepreneur else he is better off working as an employee. His salary is the ‘opportunity cost’ for him to be an entrepreneur.