Preferred return
Also called Pref, Preferred.
A preferred return is a threshold rate of return that limited partners receive on their capital before the general partner participates in profits beyond its own pro rata share. It is a priority in the distribution queue, not a promise that the money will be there.
How it works
The word preferred describes seniority, not certainty. If the property does not generate cash, the pref is not paid. What happens to the unpaid amount is determined by two structural choices that are frequently glossed over in a term sheet and that change the economics substantially.
The first is cumulative versus non-cumulative. A cumulative pref accrues when it is not paid and must be made whole before the general partner sees any promote. A non-cumulative pref that is missed in a year is simply gone. Institutional structures are almost always cumulative, and any structure that is not should be read very carefully.
The second is simple versus compounded. A simple pref accrues on the original contributed capital only. A compounded pref accrues on unpaid accrued pref as well, so unpaid amounts earn the pref rate themselves. On an 8 percent pref over a five-year hold with nothing paid currently, simple accrues to 40 percent of capital while compounded accrues to 46.9 percent, and the entire difference comes out of the general partner's promote.
Formula
Compounded accrual over n years = capital x ((1 + pref rate) raised to the power n - 1)- Simple accrual over n years = capital x pref rate x n
- Cumulative means unpaid pref carries forward; non-cumulative means it is lost
- An IRR-based hurdle is a related but different structure: the test is the LP's realised IRR rather than a running accrual balance
Worked example
Illustrative. $10,000,000 of limited partner capital, 8 percent preferred return, five-year hold, no current distributions.
| Simple accrual over five years | $4,000,000 |
|---|---|
| Compounded accrual over five years | $4,693,281 |
| Difference | $693,281 |
| Where the difference comes from | the general partner's promote |
| Compounded pref as a share of capital | 46.9% |
One word in a term sheet is worth $693,281 on a $10 million commitment. It is the single highest-value clause to read carefully in a partnership agreement.
Conventions worth knowing
- Common preferred returns run 6 to 10 percent, with 8 percent the most frequently seen starting point. The rate matters less than whether it is cumulative and compounded.
- Ask whether the pref accrues on contributed capital or on unreturned capital. Once capital has been partly returned through a refinance, the two diverge sharply.
The common mistake
Quoting a pref rate without its accrual mechanics
An 8 percent preferred return can mean at least four materially different things depending on whether it is cumulative or not and simple or compounded, and the spread between the best and worst version for a limited partner runs into hundreds of thousands of dollars on a $10 million commitment. The rate is the least informative part of the clause. Model the actual accrual mechanics from the operating agreement, and if a deal is being compared on pref rate alone, the comparison is not measuring what it thinks it is measuring.
Related terms
- Distribution waterfallA distribution waterfall is the ordered set of tiers that determines how cash is split between limited and general partners. Each tier is filled completely before any money reaches the next one, and the general partner's share rises as it goes.
- PromoteThe promote is the general partner's share of profits in excess of its pro rata capital contribution, earned once the limited partners have received their capital back plus the preferred return. It is the performance compensation in a real estate partnership.
- GP catch-upA general partner catch-up is a waterfall tier in which the general partner receives most or all of the distributions after the preferred return has been paid, until it has received its full promote percentage of all profit distributed so far. It restores the economic bargain the preferred return interrupted.
- Equity multipleThe equity multiple is total distributions divided by total equity contributed, expressed as a multiple. A 2.0x means an investor received two dollars back for every dollar put in, counting the original dollar.
- Internal rate of returnThe internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualised percentage.
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.