Key Takeaways

  • Preferred equity provides investors priority returns before common equity holders, often structured as either “hard” (debt-like) or “soft” (equity-like).
  • In real estate, preferred equity bridges funding gaps when senior debt or mezzanine financing is unavailable.
  • It offers flexibility for sponsors and managers, but may limit upside potential for investors.
  • Preferred equity is increasingly used in private funds and institutional structures for liquidity solutions.
  • Common risks include conflicts with senior lenders, poorly structured agreements, and misaligned investor expectations.

Preferred Equity: What is it?

Preferred equity is a general term used to describe any class of securities (stock, limited liability units, limited partnership interests) that has higher priority for distributions of a company’s cash flow or profits than common equity. Typically, all cash flow/profits remaining after required payments to a company's lenders are distributed to the preferred equity investors until they receive the full amount of a previously agreed upon return, commonly stated as a fixed percentage annual rate.

Preferred equity can also be thought of as form of equity measurement that takes into account the company’s preferred shareholder equity and disregards common shareholder equity. Another way to put it is that preferred equity equals total shareholder equity less common shareholder equity.

As with common equity, preferred equity represents an ownership interest in the company. That interest, however, is unsecured and does not provide its holders with direct recourse to company assets, as is the case with secure debt holders.

Preferred equity investment can be complicated and should not be considered without the advice of competent legal and financial counselling.

Features of Preferred Equity Compared to Common Equity

Preferred equity differs from common equity in several ways. While both represent ownership interests, preferred equity often comes with contractual rights to dividends or distributions at fixed rates, which must be paid before common equity holders receive returns. Unlike common equity, preferred equity typically does not include voting rights, reducing investor influence over company operations. However, in some structures, preferred investors may gain protective rights, such as approval over significant business decisions, especially if returns fall into arrears.

Preferred Equity and Real Estate

Preferred equity is widely used to describe a specific type of investment in commercial real estate projects. Investors buy a direct ownership interest (“equity”) in a limited partnership (LP) or limited liability company (LLC) that owns real property. In return, the investors get the right to receive a fixed rate of return on their investment (typically 12-16% per year) that is paid before other ownership interests in the LP or LLC. Preferred equity investors are repaid the original amount of their investments either at a set date (the “maturity date”) or when the property is sold.

The company owning the subject real property will usually have different classes of investors and tiers of lenders. Preferred equity holders rank senior to investors who own common equity, but rank junior to the holders of the loans (or bonds) used to finance the real estate project. In other words, when the property generates income from rent-paying tenants, or profits when the property is sold, preferred equity holders are paid after the lenders (or bond holders), but before common equity holders.

Preferred Equity vs. Mezzanine Financing in Real Estate

Although both preferred equity and mezzanine loans occupy a position between senior debt and common equity, their legal and financial structures differ. Mezzanine financing is structured as a loan secured by a pledge of equity interests, often requiring foreclosure under the Uniform Commercial Code (UCC) in the event of default. Preferred equity, on the other hand, is structured as an ownership interest, allowing remedies to be enforced directly under the entity’s operating agreement. This streamlined enforcement can make preferred equity more efficient in distressed real estate situations.

Why is Preferred Equity important in Real Estate?

Using preferred equity in real estate projects allows the project sponsors to contribute less of their own money, while providing preferred equity investors a higher-yielding investment that generates consistent cash flow when interest payments are made. Preferred equity investments are less risky than common equity investments because preferred equity investors get paid before common equity investors. Because the rate of return is fixed, however, the returns of preferred equity investors are capped (unlike the riskier investment of common equity investors) and do not have the same upside potential as common equity investments.

Project sponsors like to use preferred equity because it is more flexible than other sources of financing. Preferred equity agreements can be designed up to function more like bank debt, or more like preferred stock in a corporation.

Role of Preferred Equity in Market Downturns

Preferred equity has become particularly significant during periods of tight credit markets. When traditional lenders reduce their loan-to-value ratios or exit markets altogether, preferred equity fills the gap by providing capital to keep projects moving. In downturns, investors value the predictability of fixed returns, while sponsors rely on preferred equity to avoid over-leveraging with senior debt. This makes it a counter-cyclical financing tool that balances risk between borrowers and investors.

Types of Preferred Equity

There are two types of preferred equity:

  • Debt (or “hard”) preferred equity. Debt preferred equity requires the LP or LLC to make regular monthly interest payments (at higher interest rates, if those payments are late) to preferred equity investors, while additionally providing those investors with remedies similar to those of lenders (banks) if the investment is not repaid by the maturity date. For example, failure by sponsors to make timely payments to debt preferred equity holders may result in the sponsors’ loss of project ownership or management control to the debt preferred equity holders.
  • Equity (or “soft”) preferred equity. With soft preferred equity, interest payments are made to soft preferred equity investors only when a project is generating sufficient cash flow (enough to pay lenders and operating expenses.) Soft preferred equity agreements often do not  have a fixed maturity date or absolute payment obligation, or come with the harsher remedies provided to hard preferred equity holders.

Structuring Preferred Equity in Private Funds

In private fund contexts, preferred equity can be tailored to meet the liquidity and return needs of both managers and investors. Common structures include:

  • Current Pay: Investors receive periodic fixed distributions, similar to interest payments.
  • Payment-in-Kind (PIK): Returns accrue and are paid at exit, deferring cash flow obligations for sponsors.
  • Hybrid Models: Combining elements of current pay and PIK to align with fund cash flows.

These structures allow managers to attract investors without triggering restrictive covenants from senior lenders, while investors gain enhanced downside protection relative to common equity.

Reasons to consider using Preferred Equity.

  • Conventional senior and mezzanine financing is unavailable or insufficient for the project.
  • The project’s sponsors want to leverage the property by more than 80% of the property’s value, that is, beyond typical mortgage investment amounts.
  • The sponsors wish to avoid investing more of their own money if lenders refuse to fund the project in the desired amount.
  • Preferred equity investors are often not required to sign an intercreditor or subordination agreement with the project’s lenders. This can simplify the transaction and permit an earlier closing date.

Advantages for Private Equity and Fund Managers

Beyond real estate, private equity and fund managers increasingly use preferred equity to:

  • Provide liquidity solutions to investors seeking partial exits.
  • Support recapitalizations of portfolio companies without diluting existing ownership.
  • Enhance flexibility in fundraising, especially when debt markets tighten.
  • Structure customized return profiles, balancing investor security with sponsor growth goals.

Reasons to consider not using Preferred Equity.

  • Traditional forms of financing are available in the amounts required by the project’s sponsors.
  • Senior lenders may decide to treat preferred equity just like subordinate debt, with a lengthy due diligence and underwriting process, and require an intercreditor agreement.
  • Preferred equity investing may not be possible if lenders won’t allow for preferred equity investors to possess effective default remedies.

Common Mistakes

  • Not finalizing the preferred equity structure with investors with enough time to allow the lenders to do the research and underwriting they wish to do (this can cause a delay in the project’s closing.)
  • Not anticipating that senior lenders may require a full underwriting process before agreeing to the preferred equity financing.
  • Not understanding that senior loan agreements prohibit preferred equity investors from exercising many potential default remedies.

Mistakes in preferred equity investment can result in significant financial losses and legal entanglement. Seeking the advice of legal and financial professionals is strongly advised before agreeing to any form of preferred equity investment.

Key Risks and Considerations in Preferred Equity

Investors and sponsors should carefully evaluate the following risks:

  • Alignment with senior lenders: If loan agreements restrict default remedies, preferred equity rights may be undermined.
  • Liquidity risk: Unlike debt, preferred equity may not guarantee fixed repayment dates.
  • Return expectations: Investors should assess whether capped returns adequately compensate for the lack of voting rights and upside potential.
  • Documentation complexity: Poorly drafted agreements can lead to disputes over cash flow waterfalls, investor remedies, or exit timing.

Engaging experienced legal and financial counsel is essential to mitigate these risks.

Frequently Asked Questions

1. What is the main benefit of preferred equity for investors?

It provides priority returns and repayment ahead of common equity holders, offering downside protection while still participating in ownership.

2. How is preferred equity different from common equity?

Preferred equity holders receive fixed returns first but generally lack voting rights, while common equity holders have voting power but take on more risk.

3. When is preferred equity most often used?

It is commonly used in commercial real estate, private funds, and recapitalizations, particularly when senior financing is limited.

4. Does preferred equity guarantee repayment like debt?

No. While it has priority over common equity, preferred equity is not debt and repayment may depend on cash flows or exit events.

5. Why might lenders view preferred equity as risky?

Senior lenders may treat preferred equity like subordinated debt, potentially requiring intercreditor agreements or imposing restrictions on investor remedies.

Next Steps

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