Preferred Return

A preferred return is a threshold rate of return that a private investment fund must deliver to its investors before the fund's sponsor can take performance-based profit. Until the investors, known as limited partners, have received back their contributions plus the preferred return on them, the sponsor, known as the general partner, receives no carried interest. The term is commonly shortened to pref, and it is also called the hurdle.

Preferred returns are a standard term in private equity buyout funds, real estate funds, infrastructure funds and private credit funds, and in single-asset real estate partnerships. They are less common in venture capital. A preferred return is a rule about the order in which profits are shared; it is not a guarantee, and if the fund performs poorly the investors simply receive less. It should not be confused with the dividend on preferred stock.

Cash coming out of a fund is divided according to its distribution waterfall, a sequence of tiers set out in the partnership agreement. A typical waterfall has four:

1. Return of capital. All distributions go to the investors until they have received back the capital they contributed, as called under each capital call.
2. Preferred return. Distributions continue to go to the investors until they have received the agreed rate of return on that capital.
3. Catch-up. Distributions go wholly or mainly to the general partner until it has received its agreed share of all profit distributed so far.
4. Carried interest split. Remaining distributions are divided in the agreed proportion, most often 80 per cent to investors and 20 per cent to the general partner.

The most common rate in buyout funds has long been 8 per cent a year, a convention that has persisted through periods of both high and low interest rates. Lower rates are found in some credit, infrastructure and core real estate funds, where expected returns are lower. The return accrues on each contribution from the date the investor paid it in until the date it is returned, so the amount depends on the timing of cash flows as well as on their size.

The fund agreement specifies whether the return compounds. A compounding pref, usually annual, adds unpaid return to the base on which future return accrues; a simple pref does not. Many agreements express the test as an hurdle rate on the internal rate of return, which is equivalent to compounding.

The preferred return on its own would give investors all of the first slice of profit and the general partner 20 per cent only of the excess. Most funds add a catch-up tier so that, once the hurdle is cleared, the general partner receives 20 per cent of the whole profit. With a full, or 100 per cent, catch-up, every distribution after the pref goes to the general partner until its cumulative share reaches 20 per cent of total profit.

Suppose investors contribute 100 and, one year later, the fund distributes 120. The first 100 returns capital. The next 8 is the preferred return. The next 2 goes to the general partner as catch-up, at which point it holds 2 out of 10 of profit distributed, or 20 per cent. The remaining 10 is split 8 to investors and 2 to the general partner. Investors end with 116 and the general partner with 4, which is 20 per cent of the profit of 20. Had the fund distributed only 106, the general partner would have received nothing.

How strongly the preferred return protects investors depends on whether the waterfall is applied to the fund as a whole or to each investment. In a whole-fund, or European, waterfall, the general partner receives no carry until investors have recovered all contributed capital and the pref across the entire fund. In a deal-by-deal, or American, waterfall, the tiers are applied to each realised investment, so the general partner can receive carry from early successes even if later deals lose money.

Deal-by-deal structures therefore rely on a clawback provision, under which the general partner must return excess carry at the end of the fund's life if, taken as a whole, investors have not received their capital and preferred return.

The preferred return is intended to ensure that the general partner is rewarded only for returns above what investors might have earned elsewhere at lower risk, and to give it a reason to return capital promptly, since the pref keeps accruing while capital is outstanding. It also interacts with fund financing: borrowing under a subscription credit line to delay calling capital shortens the period over which the pref accrues, which makes the hurdle easier to clear and has drawn criticism from investor associations.

The mechanism has other weaknesses. A general partner whose fund is far below the hurdle, with little prospect of earning carry, may lose motivation or hold assets in the hope of a recovery. Investors negotiate these terms through the limited partner commitment process, and the amounts are tracked by the fund administrator and reported in each distribution notice. In hedge funds, the comparable protection is the high-water mark applied to the performance fee.