What is Preferred Return and How to Calculate It?

 
 
 

What is Preferred Return?

Preferred Return, often called ‘pref’, is a minimum return that Limited Partners in a fund must receive before any carried interest can be distributed to General Partners. A preferred return is expressed as an annual rate of return and can be thought of as the minimum expected return for the investment.

Limited Partners will receive 100% of their gross distributions until they have reached a certain rate of return on their investment in the fund. Once this rate of return has been met, General Partners will start to earn carried interest.

How is Preferred Return calculated?

Each Fund’s Preferred Return calculations are defined by the Limited Partnership Agreement that governs the fund. Fund’s calculations can vary in several ways. The most common variations are in the compounding periods of the preferred return rate, and the method for calculating elapsed time between periods.

For example, Fund A might specify that preferred return on any given capital call starts accruing when the call is funded and stop accruing when the applicable distribution of preferred return is made. Fund B might specify that for preferred return calculation purposes, any capital call or distribution is said to have taken place on the last day of the calendar month in which the capital call or distribution occurred. Now imagine a scenario where both Funds call capital on January 1, 2020 and distribute proceeds on December 31, 2020. In this scenario, Fund A investors are receiving preferred return based on 365 days of accrual, while Fund B investors are only receiving 335 days of accrual since the capital call is considered on the last day of the month.

 

EXAMPLE:

Investor A contributes $1MM into Real Estate Fund 1, LLC on December 31st, 2020. On December 31st, 2021, Real Estate Fund 1, LLC announces a distribution. Investor A’s gross share of the distributable proceeds is $2MM. Assuming the following structure, what Investor A’s preferred return, and total distributions?

Step 1: Calculate Preferred Return Owed

Investor A contributed $1MM 365 days prior to the distribution. To calculate preferred return, we use the following formula:

Contribution * (1+R)^(#Days/365)

  • R= Preferred Rate of return, in our case 8%

  • #Days = 365 (12/31/21-12/31/20 = 365 DAYS)

  • Contribution = $1MM

Using the above formula, we can calculate that Investor A is due $80,000 in preferred return. This also passes the gut check, since the capital contribution was made exactly 1 year prior, and the preferred rate of return is 8%.

Step 2: Calculate the Total Distribution

We know that the investor is first due their original $1MM capital contribution, plus $80k in preferred return. This leaves $920k to be allocated between Limited Partner and General Partner. Referencing the assumptions table above, we see that any distributions after preferred return has been met are allocated 80% to Limited Partner, and 20% to General Partner. Thus, of the remaining $920k, the Investor A gets $736k, and the General Partner gets $184k. Combined with the return of capital and preferred return, the $2MM gross distribution will be split as such:

Conclusion

Preferred Return is a major part of any real estate or private equity fund. The preferred return rate determines when General Partners will receive carried interest and sets a baseline performance expectation for Limited Partners. The calculation of preferred return can be difficult, and small LPA language differences such as the one detailed in the example above can cause major differences in distributions. Understanding preferred return is extremely important for all investors and managers, since preferred return marks the boundary between LP distributions and GP promote.

About the Author

Eric Bergin is the founder of TSM. He realized that there was a need for real estate financial models that were more than just generic templates. He wanted to create a personalized product for his customers that would ensure success for them and their company. Please reach out to him if you have any questions regarding discounted cashflows or if he can help you with your modeling needs.

 
Eric Bergin