Comparing a cumulative pref structure against a straight IRR hurdle on two LP offerings

Cumulative and compounding does matter, and the reason is arithmetic rather than fairness. If Deal A distributes 4 percent in year one against a 7 percent pref, the 3 percent shortfall accrues and compounds at 7 percent until it is paid. Over a 5 year hold with two weak years that unpaid balance can be worth several points of total return, and it sits ahead of the sponsor in the waterfall. Deal B's 8 percent IRR hurdle has no memory of a weak year in the same way. IRR is time weighted, so a slow start does hurt the sponsor's ability to clear the hurdle, but there is no accruing claim the LP owns. The clause to hunt for in both documents is what the pref is subordinate to. In most structures the pref sits behind the asset management fee, capital reserves and debt service, which is normal, but some agreements let the sponsor defer the pref indefinitely at their discretion and make accrued pref payable only from sale proceeds. That last version means a compounding pref is a claim on an exit that might not happen when projected. Also check whether Deal A's promote is subject to a clawback at the end and whether either has a catch-up provision after the hurdle. A 70/30 split with a full catch-up is not a 70/30 split. And read the capital call language in both. It is the paragraph most LPs skip.

A preferred return is the return LPs get paid before the sponsor gets any profit share, so that's worth spelling out for anyone else reading this. Cumulative means unpaid amounts pile up rather than disappear.

What I don't get is why any sponsor would offer no pref at all. Doesn't that make the deal harder to raise?

@bmoreno23 I wondered the same. My guess is that a sponsor with nine exits doesn't need to offer as much to raise money, which is sort of the answer to @priya_n21's whole question. The market's already priced the track record into the terms.

@kevin_lombard that's the sharpest thing in this thread and I think it's mostly right, but it cuts both ways. Sometimes the tighter terms are the market paying for a real record. Sometimes they're a sponsor who got used to raising easily and hasn't updated.

@priya_n21, on your basis points question, I don't think there's a number. What I'd do instead is call two LPs from each sponsor's prior deals and ask one thing: what happened the last time a deal underperformed the projection. You'll learn whether the sponsor called early, cut distributions cleanly, and told people the truth, or whether investors found out from a delayed K-1. That behavior is worth more than the waterfall difference between these two, because a sponsor who mismanages a bad year gives you nothing to be preferred to.

On my side of the business, the difference between three deals and nine deals is mostly whether they've eaten a real cost overrun yet. Deal A's sponsor with three exits may never have had a project go 30 percent over scope. That's not disqualifying. It's a question to ask directly.

Also, 96 units versus 180 units is a different operating problem. Ask B whether they self-manage and what their staffing plan is at that unit count.

Nobody has said the obvious thing, which is that $50k into one deal every year for three years means you now hold three positions and are about to hold four. That is a thin book to be optimizing waterfall terms in. Take whichever sponsor lets you write a smaller check so you can do both, even at $25k each, and if neither will, take the one whose reporting you'd rather read for six years.