When does a preferred return make sense for cash providers?

Question

I know what a preferred return is, and I've heard people say that there are deals when it makes sense, and deals when it doesn't. Obviously I'm only looking at equity deals here.

Thanks!!

Andrew Hogan · Answer

Good question Clark, it depends what your personal goals are. Do you care more about current cash flow, or growing your wealth bucket longterm? Typically more experienced MF syndicators will give you a lower initial preferred return of  6-7% while they give you a better backend of 70-75% when the asset refis or exits. Then you'll usually see lesser experienced or sponsors with heavier value-add deals give you a higher initial preferred return but only give the LP 50-60% on the backend.

That being said, the preferred return isn't guaranteed, so what makes the most sense is the sense you make of the sponsor.

Tj Hines · Answer

@Clark Kirkpatrick in my eyes a preferred return only makes when the sponsor is absolutely sure he can hit those projections in the 1st yr. for instance let’s say a sponsor is offering a 8% preferred return and only hits 4% in the 1st yr. the following yr the sponsor now has to return 12%   In yr 2 the sponsor returns 6%  now in yr 3 the sponsor has to return 14 %.  This isn’t cool to me from the sponsors standpoint. Essentially the sponsor could work the deal for 5, 7 or 10 yrs before they get a payout. Through the liquidation of the sale will the sponsor be able to catch up pay those preferred returns.

Spencer Gray · Answer

The preferred return in many ways is a measure of perceived risk and the premium paid by the sponsor to the investor for that risk. The higher the preferred return the higher level of perceived risk. That risk is mostly related to the experience of the sponsor just as @Andrew Hogan explained.

A preferred return doesn't make as much sense in deals where there is no or very little cash flow in the the deal such as a new development or a very heavy rehab/reposition. There still may be a preferred return as LPs want some idea of a minimum return on their equity even if it is accruing not not actually being distributed. In these deals instead of a preferred return there may be a series of waterfall hurdles bases on the IRR of the project. This is often more useful from a sponsors perspective since there is no pref being accrued and the splits are based on the eventual disposition or other capital event.

Mike Dymski · Answer

The preferred return exists to compensate LPs first for taking on the risk of lost capital.

Clark Kirkpatrick · Answer

Thanks for your responses!!

I hadn't thought about any of these things - just finished Matt Faircloth's book Raising Private Capital and I'm trying to create a system to start doing that properly, and this is really helpful for me!

Greg Scully · Answer

@Clark Kirkpatrick - It can also be driven by your investor expectations.  Some people have very specific goals and just want to hear their number in the deal.

When does a preferred return make sense for cash providers?

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