What does a preferred return actually buy the money side?

Question

I've been reading two JV term sheets a friend forwarded me with the names taken out, and they split the same way on paper but they get there differently.

The first one gives the capital an 8% preferred return, meaning the money gets paid first up to that rate before the operator sees any share of profit, and then the operator takes a bigger slice above it. The second has no pref at all. Everybody splits every dollar in proportion to what they put in, so if I fund 90% I get 90% of everything from the first dollar to the last.

The case for the pref is that it puts my capital in line ahead of the operator's upside, so a mediocre deal pays me before it pays him. The case against is that a pref accrues whether the deal earns it or not, and if it doesn't earn it, the operator is working for free and eventually stops working. The flat split is honest in a plain way, we win and lose in the same proportion, and nobody is grinding toward a hurdle they can't reach.

I genuinely don't know which one I'd rather sign as the check writer. Where does the room land?

hannah_west29 · Answer

The pref isn't a payment, it's an order of payment. That's the part people miss. An 8% pref on $500k accrues $40k a year of priority, and if the deal only throws off $25k of cash in year one, the unpaid $15k either compounds or sits there simple depending on one sentence in the waterfall. Ask which. The difference over four years on that example is real money.

Where the flat split wins is on a short hold. On a 14 month value-add, a pref barely gets a chance to bite, and all you've done is add three pages to the agreement. Where the pref wins is when the deal drifts to 5 years and the operator's attention wanders. Then the accrual is the only thing reminding him my money has a clock on it.

So my answer depends on whether the operator can survive being paid nothing for two years. If he can't, the pref is decorative and he'll come back asking to restructure it.

sonia_alvarez · Answer

@ledger's point about survival is the one I'd chase. I look at the operator's personal burn before I look at the waterfall. A guy with a management company producing fee income can wait out a pref. A guy whose only income is this deal cannot, and a pref on him just means an awkward conversation in month nine.

One thing for @sable since you're new to reading these: pref and promote are two separate levers and term sheets often move them together to make the same total split look different. A low pref with a fat promote and a high pref with a thin promote can land within a point of each other at the likely outcome. Run both at the same exit price before you decide you prefer one.

What does a preferred return actually buy the money side?

2 replies