What Is a Preferred Return?

A Preferred Return is a clause in an investment agreement that gives certain investors priority to receive profits or distributions before other equity holders have a chance to share the profits. This is the way it is mostly used in private equity, venture capital and other investment contexts.

Putting it simply, Preferred Return is a fixed rate of return that must be met or exceeded before the investor can start sharing the profits with the sponsor, general partner, or other participants in the deal. It should be emphasized here that a preferred return is in no way close to a guaranteed return, as the actual distribution depends on how much cash flow the investment can generate and the terms of the investment agreement.

How Does a Preferred Return Work?

A typical Pref Return is expressed as an annual percentage of an investor’s eligible capital. For example, an investment agreement may provide for an 8% preferred return.

The distribution process may generally work as follows:

1. Investor contributes capital: The investor provides funds to the investment.
2. Preferred return accrues: The agreed return is calculated according to the investment terms.
3. Investors receive priority distributions: Available profits or distributions are allocated according to the agreed waterfall.
4. Remaining profits are distributed: Once the preferred return threshold is satisfied, additional profits may be shared between investors and sponsors according to the agreement.

Types of Preferred Returns

Preferred Returns can have different structures, including:

• Simple preferred return: Calculated on the applicable investment amount without compounding.
• Cumulative preferred return: Unpaid amounts may accumulate for future periods.
• Compounding preferred return: Accrued returns may themselves become part of the amount used for future calculations.
• Non-cumulative preferred return: Unpaid returns may not carry forward, depending on the agreement.

Why Is a Preferred Return Important?

A Preferred Return will help to ensure alignment of interests of investor and sponsor by setting a baseline for the order of distributions that precede some of the profit-sharing arrangements. Investors should pay close attention to how a preferred return is calculated, who will get what, if and when, and whether the returns will be compounded, and they should read the waterfall clause for distributions carefully since these provisions can greatly impact their return.

Want Help With Your Finance and Accounting Operations?

Atidiv helps businesses streamline accounting, financial reporting, finance operations, and back-office processes. Accurate financial records can support investment reporting, distribution calculations, and better financial visibility.

Talk to an Atidiv expert to strengthen your finance and accounting operations.