A preferred return, also known as a “preferred yield” or “hurdle rate,” is a minimum rate of return guaranteed to a particular class of investors, such as preferred shareholders or passive investors, before other investors, such as general partners, receive any returns on their investments. Now, the term “guaranteed” can be misleading. There is no GUARANTEE in investing; however, this is the amount of return an investor will receive BEFORE the sponsor in the deal receives compensation.
The preferred return, or “pref,” is specified in the investment agreement and package and is often a highlight of the marketing materials. This is used to compensate preferred shareholders for the higher risks they are taking compared to traditional investments, such as stocks or bonds.
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How is Preferred Return Calculated?
The calculation of a preferred return can vary depending on the terms of the investment agreement. However, in most cases, the preferred return is calculated as a percentage of the invested capital. For example, if an investor invests $100,000 with a preferred return of 8%, they would receive a preferred annual return of $8,000.
Sometimes, the preferred return may be calculated based on the invested capital (capital contribution) plus any accrued interest. For example, if an investment agreement specifies a preferred return of 8% per year, the investor would receive 8% of the invested capital each year. Any unused preferred return would accrue interest for the following year.
It’s important to note that the preferred return is usually paid out on an annual or semi-annual basis and is often subject to a cap or limit, which means that the preferred return may stop accruing once it reaches a certain level.
In a real estate project, the preferred return may be calculated based on the property’s net operating income. In private equity investments, it may be found in the portfolio’s overall performance. Alternative assets or alternative investments can vary, but a preferred return is common.
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Why is Preferred Return Important?
Preferred return is essential for a few reasons:
- Risk mitigation: Preferred return provides a minimum level of return for investors above their initial investment, which can help mitigate the risks associated with investing in higher-risk assets such as private equity or a real estate deal. This minimum return acts as a safety net for investors, ensuring they will receive some level of return on their investment, even if it does not perform as well as expected. In this scenario, the sponsor will not receive management fees or a performance fee.
- Priority of returns: Preferred return is usually paid out before other distributions are made to other investors, such as common shareholders. This means that preferred shareholders have priority over other investors regarding receiving returns on their investments.
- Alignment of interests: Preferred return helps to align the interests of the investors and the managers of the investment. Suppose the manacle generates a return that exceeds the preferred return. In that case, they are incentivized to maximize returns for all shareholders, as this will result in higher returns for themselves. If the project meets the pref, then the cumulative return will be higher and a waterfall structure will then be implemented.
- Attractiveness to investors: Preferred return can make an investment more attractive to investors, especially those looking for a higher level of certainty regarding the returns they will receive. This can help attract a wider pool of investors, which can benefit the investment and its managers. It ensures focus on not only the internal rate of return but on the hurdle rate and true preferred return to all shareholders.
In conclusion, preferred return is an essential component of many investments, as it provides investors with a minimum level of return, a priority of returns, a mechanism to align interests, and can increase the attractiveness of the investment to potential investors.
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Private Equity Investment Terms
Private equity investments have important terms and jargon that can confuse those unfamiliar with the industry. Here are some standard terms used in private equity investments:
- Limited Partner (LP): A limited partner is an investor in a private equity fund with limited liability for the debts and obligations of the fund. LPs provide capital to the fund and receive a share of the profits generated by the fund’s investments.
- General Partner (GP): The general partner is responsible for managing the private equity fund and making investment decisions on behalf of the limited partners. The GP typically receives a management fee for its services and a share of the profits generated by the fund’s investments.
- Carried Interest: Carried interest is the share of profits that is paid to the general partner in private equity funds. It is typically a percentage of the profits generated by the fund’s investments and is used to incentivize the GP to maximize returns for the limited partners, including cash flow.
- Fund Size refers to the total amount of capital committed to a private equity fund. Fund size can significantly impact the types of investments the fund can make and the returns it can generate.
- Investment Horizon: Investment horizon refers to when a private equity fund is expected to hold its investments. Investment horizons can range from a few years to several decades, depending on the specific investment strategy of the fund.
- Leverage: Leverage refers to the use of debt to finance investments. Leverage is often used to increase the potential returns of investment by amplifying the impact of the equity invested.
- Exit: An exit refers to the sale of an investment or the realization of returns on investment. Exits are typically realized through the sale of a project.
- Liquidity: Liquidity refers to the ease with which an investment can be sold or converted into cash. Private equity investments are often illiquid, meaning they cannot be quickly sold or converted into cash.
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Preferred Return Vs. Preferred Equity
Preferred return and preferred equity are two different concepts in finance and investments.
Preferred return refers to a minimum rate of return (preferred return hurdle) that an investor is guaranteed to receive on their investment before other investors receive any returns. This rate of return is often specified in the investment agreement and may be calculated as a percentage of the invested capital. Preferred return is often used in private equity and real estate investments to provide investors with a minimum level of certainty (almost a guaranteed payment)
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Preferred equity, on the other hand, refers to a type of equity security that prioritizes common equity when it comes to receiving dividends or distributions. This refers to private equity firms that provides capital in the second position of the capital stack taking a higher tier position than the Limited Partners and 2nd only to primary debt (bank Loan).
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Pari Passu Preferred Return
An accurate preferred return and a pari passu preferred return are two different types used in private equity and real estate investments.
Pari Passu Preferred Return:
A pari passu preferred return is paid to investors on a pro-rata basis, meaning that all investors receive the same percentage of return distributions on their investment. In a pari passu structure, the pref is paid out to all investors simultaneously, regardless of their investment amounts. In this structure, all investors receive the same percentage of returns, but those with more significant investments will receive a more considerable absolute return.
See the Following Examples below for illustrative purposes:
Common Equity with a Pari-Passu Pref
Simple Vs. Cumulative Preferred Return
Simple preferred and cumulative preferred returns are two types of preferred returns used in private equity and real estate investments.
Simple Preferred Return: A simple preferred return is paid out to investors periodically, such as annually or quarterly. In a simple preferred return structure, the preferred return is paid out as long as the investment generates sufficient returns. The expected return will only be paid out if the acquisition generates enough returns to cover the desired return.
Cumulative Preferred Return: A cumulative preferred return that accrues over time and is paid out only when the investment generates sufficient returns to cover the cumulative amount of preferred return that has accrued. In a cumulative preferred return structure, if the investment does not generate enough to cover the cumulative amount of preferred return that has accrued, the preferred return will accumulate and be paid out later when the investment generates sufficient returns.
The Lookback Provision
A lookback provision is a clause in a private equity or commercial real estate investment agreement that allows the investment manager to adjust the preferred return in certain circumstances.
The lookback provision typically allows the investment manager to “look back” at the performance of the investment over a specified period, such as a year or several years. Suppose the investment has performed better than the preferred return. In that case, the investment manager may adjust the preferred return upward to a higher rate to reflect the higher returns generated. On the other hand, if the asset has performed worse than the preferred return, the investment manager may choose to adjust the preferred return downward to a lower rate to reflect the lower returns generated by the investment.
The lookback provision is often included in investment agreements to ensure that the preferred return remains aligned with the actual return generated by the investment. It allows the investment manager to adjust the preferred return to ensure that the investment remains attractive to a potential investor while also allowing the investment manager to share in the benefits of any outperformance of the investment.
In conclusion, a lookback provision is a clause in an investment agreement that gives the investment manager the option to adjust the preferred return based on the performance of the investment over a specified period. This provision ensures that the preferred return remains aligned with the actual returns generated by the asset.
The Catch-Up Provision
A catch-up provision is a clause in a private equity or real estate investment offering that allows for the payment of accumulated preferred return in the event of good future investment performance.
In a cumulative preferred return structure, if the investment does not generate sufficient returns to cover the cumulative amount of preferred return that has accrued, the preferred return will accumulate and be paid out later when the investment generates sufficient returns. The catch-up provision specifies the conditions under which the accumulated preferred return will be paid out, such as a certain level of investment performance or the sale of the investment.
The catch-up provision assures private equity investors that they will eventually receive their accumulated preferred return, even if the investment generates insufficient returns in the short term. It also allows the investment manager to defer the payment of the accumulated preferred return until the investment is in a better position to generate sufficient returns to cover the cumulative amount of desired return that has accrued.
In conclusion, a catch-up provision is a clause in an investment agreement that allows for the payment of accumulated preferred return in the event of good future investment performance. This provision assures passive real estate investors that they will eventually receive their accumulated preferred return and provides the investment manager with the flexibility to defer the payment of the accumulated preferred return until the investment is in a better position to generate sufficient returns.
This article is for informational purposes only. You should seek investment advice from your attorney and CPA before entering into any agreement.
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As a top-performing sales professional in supply chain/logistics for almost 20 years, Jeff Davis has been putting his commissions to work for him in real estate since 2015 and is now partnered in almost 2000 units across 4 states in the US.