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Preferred Return

What is a Preferred Return?

A preferred return is a profit distribution preference in which profits are distributed to one class of equity before another until a certain rate of return on the initial investment is reached, providing a level of comfort and predictability for investors. Commonly used in real estate and private equity investments, it serves as a hurdle rate that must be met before the sponsor or general partner can earn their carried interest or "promote."

Types of Preferred Returns

Preferred returns can be categorized into different types based on their structure and distribution. The main types include:

  • True Preferred Return: Profits are distributed to investors before the sponsor receives any money.
  • Pari-Passu Preferred Return: Profits are distributed pro-rata between investors and the sponsor.
  • Simple Preferred Return: A non-compounding return, where investors receive a fixed percentage return each year.
  • Cumulative Preferred Return: A compounding return, where any unmet preferred return from previous years is added to the investor's capital account for calculating the next year's preferred return.

Calculating Preferred Returns

Calculating preferred returns involves determining the minimum return that investors must receive before the sponsor or general partner can participate in the profits. Preferred returns can be calculated in different ways, such as a percentage (e.g., an 8% cumulative return on initial investment) or as a certain equity multiple. They can also be calculated on a simple interest basis or a compounding basis.

It's important to consider factors that can affect preferred returns, such as the performance of the property, the structure of the investment, and market conditions. Keep in mind that preferred returns do not guarantee distributions will happen on a specific timeline, as the extent and timing of those distributions depend primarily on cash flow from the property.

Preferred Return Impact on Investment

Preferred returns impact investment by providing:

  • Security: They offer a baseline return to investors, prioritized over other types of equity.
  • Incentive: They motivate fund managers to surpass the preferred return threshold to reach the profit-sharing phase.
  • Stability: They can make investments more attractive by offering predictable returns in volatile markets.

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