The basic structure
In its simplest form, a preferred return works like this:
- An investor puts in $1,000,000 at an 8% preferred return.
- Before the sponsor receives any distributions, the investor receives their 8% annual return on capital equaling $80,000 per year.
- Once the investor has received all accrued preferred returns, distributions flow to the residual holders (usually the sponsor and other equity participants).
The investor is not guaranteed to receive this return since it is contingent on the project generating sufficient cash flows. But they are guaranteed to receive it before anyone else.
Why it matters structurally
A preferred return creates a separation between income return and equity return. The investor gets income-like certainty through the preferred tranche. The sponsor gets to retain the equity upside above the hurdle.
This is a trade and not altruism on the sponsor's part. The investor accepts a lower overall return expectation in exchange for priority. The sponsor gives up income priority in exchange for keeping the upside.
The catch-up mechanism
In many structures, after the investor has received their preferred return, the sponsor receives a "catch-up" which is a disproportionate share of the next tranche of distributions until they have received an equivalent return on their equity. Then, above the catch-up threshold, distributions split at a negotiated ratio.
Compounding or non-compounding?
The choice between compounding and non-compounding preferred returns has a significant impact on economics. For sponsors, non-compounding is almost always preferable. For investors in risky projects with uncertain early cash flows, compounding provides more protection.
When to use it
A preferred return structure is appropriate when a project has cash flows sufficient to service a defined return, when an investor needs income-like certainty, and when a sponsor needs capital without selling large equity stakes at an early valuation.