8% pref that compounds against 10% simple with a better split

Question

Two term sheets on my desk, both value-add multifamily, similar markets, similar leverage, similar stated hold of five years.

Deal A: 8% preferred return, cumulative and compounding on unpaid amounts, then 70/30 split of everything above the pref in favor of LPs. No catch-up.

Deal B: 10% preferred return, simple, non-cumulative on any quarter that misses, then 80/20 split above the pref.

The case for A is that the pref keeps working while nothing gets paid. If distributions pause in year two, the accrual compounds and I get made whole with interest on the delay before the sponsor sees a dollar of promote. It's the structure that pays me for waiting.

The case for B is that 10% is 10% and in the years the deal performs it's simply a bigger number, plus 80/20 above it means I keep more of the upside if the exit is strong. Non-cumulative is the ugly part, a missed quarter is gone rather than banked.

I've run it both ways and the answer flips depending on hold length and how lumpy the distributions are, which is exactly the thing I can't know in advance. Where do you land?

ryanmck27 · Answer

Non-cumulative reads brutal to me. It means the sponsor's incentive during a rough stretch is to skip the quarter and start clean, and I can't see how a passive investor ever prices that. Am I misreading how those clauses usually get drafted, or is it as bad as it looks?

bmoreno23 · Answer

Question about pref structures, since I'm still learning the vocabulary. Cumulative means unpaid pref piles up and has to be paid later, non-cumulative means a missed quarter just evaporates? And compounding means the pile itself earns pref? If that's right then Deal B's 10% only beats Deal A in a deal that pays every single quarter on time, which sounds like the deal nobody actually gets.

chriswalton8 · Answer

@ember you've got the definitions right. The thing I'd add is where the promote actually gets paid from. In A the sponsor sees nothing until your accrued balance including compounding is cleared, so in a slow deal their upside gets pushed to the sale. That changes behavior, and not always in your favor, because a sponsor with no promote in sight until exit has a reason to swing for a big exit rather than a safe one.

hannah_west29 · Answer

Ran it on $100k with no distributions until sale, which is the stress case.

8% compounding: year 4 accrual is about $36.0k, year 6 about $58.7k, year 7 about $71.4k. 10% simple: year 4 is $40k, year 6 is $60k, year 7 is $70k.

So simple 10 is ahead through about year six and compounding 8 pulls in front somewhere in year seven. Both of these deals say five years, which puts the crossover past the stated hold, and that favors B on the pref alone.

Then the split does the rest of the work. On a deal that returns $100k of profit above the pref, 80/20 gives you $10k more than 70/30. That's a bigger swing than the pref difference over a five year hold in most of the cases I ran. B wins unless distributions get suspended for multiple years, in which case non-cumulative wipes out the whole advantage and A wins by a lot.

So you're really voting on whether you think this deal pauses distributions. @parcel what's the sponsor's history on that, and does B define what a "missed" quarter is or just leave it to the manager's discretion?

tashaford30 · Answer

@ledger that's the clearest version of this I've seen. What worries me about B is that it makes me bet on the good case, and I'm choosing a first deal specifically to survive the bad one. I'd take the structure that protects me when things go sideways even if it costs me a few points when they don't.

diane_kowalski · Answer

The stated five year hold is doing more work in this comparison than either pref rate. Every deal I've watched from the outside ran long, and once you're in year seven the compounding cumulative pref is the only clause that still cares about you. I'd want to know what the agreement says about extending the hold and who gets to decide, because that single provision moves @ledger's crossover date into the range where A is clearly better.

8% pref that compounds against 10% simple with a better split

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