Preferred Return is a common mechanism in Limited Partnership Agreements for Funds. A Preferred Return is the annual rate of return which the Limited Partners in a Fund must achieve before the General Partner starts to share in distributions. The Preferred Return is calculated on Limited Partner’s capital contributions. Preferred Return Clause can be thought of as the minimum annual yield for the Limited Partners, the baseline performance metric. Preferred Return rates vary by asset class and market conditions, but generally range around 8%.
Catch-Up Provision
Catch-Up provisions are also common in Limited Partnership Agreements for Funds. Unlike the Preferred Return, the Catch-Up provisions heavily favor the General Partner. The idea of a Catch-Up provision is to heavily allocate distributable proceeds to the General Partner, until they have received a certain percentage of profits. Catch-Up provisions are usually immediately after the Preferred Return tier. Catch Up provisions generally allocate anywhere from 50% to 100% of distributions to the General Partner. Since 100% of the dollars before this tier go to the LPs, the Catch-Up tier allows for the GP to catch-up to their distribution share.
Carried Interest
Carried Interest, also called promote, is the disproportionate share of proceeds that the General Partner receives. Carried Interest is an incentive to General Partners to effectively manage the investments they oversee. Effective performance-based provisions, like the Preferred Return clauses discussed above, ensure that the Limited Partners still receive an acceptable return on their investment before a General Partner starts to earn Carried Interest.
IRR Hurdle
IRR Hurdles are most commonly found in Joint Venture Agreements and Limited Partnership Agreements for single investments. IRR Hurdles work very similarly to Preferred Return. An IRR Hurdle allocates distributions according to some percentage until the Limited Partner has reached the designated IRR, and thereafter allocates according to some other percentage. The main difference between a Preferred Return and IRR Hurdles is that an IRR Hurdle based waterfall will usually have multiple IRR Hurdles, and the cashflows will get generally more disproportionate as the distributions trigger the higher IRR Hurdles.
Examples of Waterfall Language:
