Preferred Return: Everything You Need to Know
A preferred return, simply called pref, describes the claim on profits given to preferred investors in a project.6 min read
Updated July 20, 2020:
What Is Preferred Return?
A preferred return—simply called pref—describes the claim on profits given to preferred investors in a project. The preferred investors will be the first to receive returns up to a certain percentage, generally 8 to 10 percent. Once you reach this profit percentage, the excess profits are split among the rest of the investors as agreed upon in negotiations. This type of return is most commonly used in real estate investment.
How Is the Preferred Return Calculated?
There are three main questions when it comes to calculating the preferred return:
- Is it compounded or non-compounded? Compounded means that the calculation of a preferred return periodic growth amount comes from the amount of invested capital plus all previously earned but unpaid amounts.
- Is it cumulative or non-cumulative? Cumulative means that all the money earned in one period that is not paid out at the end of that period are carried forward to the following period.
- Off of whose capital is the preferred return measured?
There is certainly no single, pre-defined structure used by all investors. Find out what works best for you and the other investors. It is important to make clear to the investor exactly how you will calculate the return on their investment. You should decide and write this information into a contract at the beginning.
Why Is Preferred Return Important?
Preferred return is a great way to reward investors who are first to the table or are willing to give a large amount of cash to the investment.
It's also a way to show to your investors that you believe you will not only reach the percentage return that you have promised them but exceed it to pay other investors. Showing the investors that you are confident that you will make a profit is a great way to attract good investors.
Private Equity Investment Terms
Preferred return is generally associated with private equity, like property investment. It is good to know the other terms associated with private equity if you are planning to have preferred return investors:
- Limited partners. Limited partners are large companies or high net worth investors — people with a lot of cash assets — interested in the income and capital gains associated with investing in a private equity fund. Limited partners do not manage the funds in any way and are protected from losses that go beyond their first investment. They are also free of any liability should the funds have legal action taken against them.
- General partners. General partners are the ones that manage the investments within the private equity fund. In return, they earn a management fee and a percentage of the fund's profits called carried interest. The general partners are legally liable for the actions of the fund.
- Carried interest. Carried interest is the general partner's share of the profits. It is usually anything from 5 to 30 percent of the profits.
- Committed capital. Money committed by limited partners to a private equity fund that is not invested right away. It is "drawn down" and invested into new things over time.
- Drawdowns. Also known as capital calls, you issue drawdowns to limited partners when the general partner has identified a new investment, and you require a portion of the limited partner's committed capital to pay for that investment.
- Return hurdle. A return hurdle is the rate return achieved before you can move on to the next hurdle. It is important to define your return hurdles because they are what trigger the percentage profit splits.
- Investment multiple. The investment multiple is also called the total value to paid-in (TVPI) multiple. You get the investment multiple by dividing the fund's cumulative distributions and residual value by the paid-in capital. The point of working out the TVPI is to give a potential investor insight into how the fund is performing.
- Realization multiple. Also called the distributions to paid-in (DPI) multiple. You get this number by dividing the cumulative distributions by paid-in capital. The realization multiple shows potential private equity investors how much of the fund's return has actually been "realized," or paid out, to current investors.
- RVPI multiple. This multiple is found by dividing the fund's residual value by paid-in capital. It gives a measurement of how much of the fund's return is unrealized and how much is dependent on the market value of the current investments.
- PIC multiple. The PIC is found by dividing paid-in capital by committed capital. This will show a possible investor the percentage of a fund's committed capital that has actually been drawn down and used for other investments.
Preferred Return Versus Preferred Equity
Preferred return is a preference in the returns on the capital investment. If you have a preferred equity position, then you receive a preference in the return of your initial capital investment.
In preferred equity investments, an investor gets their initial investment back along with a set percentage return on their investment before any of the other investors get a penny.
The True v. Pari Passu Preferred Return
An investor in a common equity position can still receive a preferred return. The type of preferred return can be determined based on the treatment of sponsor capital, also called the co-investment.
If the investor receives a preferred return, such as profits, before a sponsor does, then the preferred return is a true preferred return. It the investor and the sponsor receive the same preferred return at the same time, then the preferred return is called a Pari-Passu preferred return.
With a true preferred return, the investor gets preferential treatment on the capital contribution. With a Pari-Passu, the investor doesn't. Instead, the pari-passu acts as a threshold up to which the investor's and the sponsor's capital are treated equally. When you go over that threshold, the sponsor capital receives a promotion.
Simple v. Cumulative Preferred Return
It's important to note that the pref is not always calculated in the same way. The sponsor can calculate the pref on a simple interest basis or on a compounding basis.
If an investor is entitled to a 10 percent annual preferred return, but in the first year there is only enough profit to pay a 5 percent return, it will be ramped up in the second year and they will pay a 15 percent return at that time to make up for the deficit.
If you use the simple interest basis, the additional 5 percent would be owed following year, but it wouldn't be added to the initial balance. In using the compounding basis, the outstanding 5 percent would be added to the investor's capital account for and used to calculate the preferred return for the next year.
The Lookback Provision
The lookback provision says that the sponsor and investor will "look back" at the end of the deal. If the investor doesn't reach a pre-determined rate of return, then the sponsor will give up a portion of the profits that have already been distributed in order to provide the investor with the pre-determined return.
The Catch-Up Provision
The catch-up provision says that the investor gets 100 percent of all of the distributions of profit until a certain amount has been reached. After the investor has reached their rate of return, 100 percent of the profits will go to the sponsor until the sponsor has caught up.
The catch-up provision is a slight variation on the lookback provision. Both are attempting to achieve the same goal. The main difference is that when using the lookback provision, the investor has to go back to the sponsor at the end of the deal and ask the sponsor to write a check, versus receiving it all upfront with the catch-up provision.
It's important to remember that there is no one solution or right answer when working with preferred returns.
Frequently Asked Questions
- Who gets a preferred return?
Anyone who is a preferred investor will be given preferred returns. They are given this preference at the time of investing. This could be all the equity investors or only a few of them.
- What is the compounding period of a preferred return?
If the preferred return is compounded, then you need to define the compounding frequency. This will be determined at the time of investment and can be annual, quarterly, monthly, daily, or continuous.
- Are the basic management fees paid to the managers prior to the preferred return?
They can be, but they are not always done this way. If there is ongoing management in the investment, then the management fees will likely be paid even though no profit has yet been made. Sometimes investors have to pay out of pocket for the management fees since all the capital has gone into the investments.
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