Preferred Return Question

4 Replies

Hi all,

Been looking at typical syndication structures and have seen a common one is to offer an 8% preferred return and then 70/30 the cash flow above that between GP/LP's.

My question is, what is the 8% preferred return based off of? 8% preferred return on the original equity contribution?

What's the difference between a preferred return and an IRR hurdle? Besides the fact that they're two different metrics, don't they basically serve the same purpose, to establish a threshold to be met before a promote incentive can kick in?

Thanks for clarifying!

Preferred return is what you get paid before GP get their cut. 

It is based on unreturned (important!) portion of the original equity. It is usually rolled forward to the next year if current year didn't have enough profit to pay full pref amount. 

In the case of capital event such as refinance pref is calculated based on the new (lower) equity position. 

Some sponsors treat regular distributions as return OF capital reducing the original equity and amount of pref over time. This is something to watch for in the offering documents. Good offerings count regular distributions as return ON capital.

To add on to what Nick said, preferred is the amount the investor is paid prior to the GP getting paid. If the pref is 6% and you invested $100,000, then you would make $6,000/year, then after you make that the remaining profit is split 70/30. 

A hurdle rate or waterfall, is based on a refi or sale. When the investor gets paid a certain amount, the split then goes down to a new rate. For instance. An example would be a 70/30 split with a 15% IRR hurdle, then 50/50 split thereafter. This is a way to award/motivate the sponsor for solid performance.

Correct So if you put $100k the Pref is 8% you would get $8k per year. The main issue to make sure is does the property actually produce or is the GP playing catching down the line or at sale.

What the preferred return and IRR is based off of also depends on how the offering documents define those terms. Don't assume a meaning because the offering docs can manipulate the components.