Exploring the Truth: Uncovering Hidden Fees in Preferred Return Structures

Uncovering Hidden Fees in Preferred Return Structures

Preferred returns are returns promised to limited partner investors. Usually they are paid through cash flow from the deal.

Base Equity Split Example:

70/30 Straight Split, 8% Preferred Return

True Preferred Return:

100% of the first 8% cash flow is distributed to investors. Above 8% is split 70/30 (70% to limited partners and 30% to general partners).

Example:

9% total cash flow on the deal, 8% true preferred return to limited partners.

The first 8% of cash flow goes directly to limited partner investors, then the remaining 1% is split 70/30. In total, 8.3% goes to limited partners and .7% goes to general partners.

This is what most limited partners think they're getting.

Pari Passu Preferred Return (Also called GP Catch Up):

Example:

9% total cash flow on the deal, 8% pari passu preferred return to limited partners.

The entire 9% is split 70/30. 6.3% to limited partners, 2.7% to general partners. Pari passu means “on equal footing.” Equal in this case means the split still applies. It only seems like the limited partners are getting a true 8% preferred return because they’re paid the first 8%. Behind the scenes, the balance owed to general partners accrues.

After the first 8% of cash flow, all of the excess goes towards paying back the amount the general partners are owed. If the amount owed to general partners is never caught up through cash flow, it will be taken out of the sale.

The pari passu preferred return structure doesn’t deliver on what most investors think they’re getting. It’s far less favorable than a true preferred return. You're getting paid first but you still owe the GP team like there was no preferred return at all.

The pari passu preferred return does benefit IRR percentage slightly to LPs compared to having no preferred return at all. This is because the return comes sooner. IRR factors in getting money earlier as more valuable than getting money later. In terms of overall returns however, a pari passu preferred return will be a couple percentage points less per year compared to a true preferred return.

Increasing Splits for a Preferred Return

If general partners include a preferred return, they will almost always raise their equity split. This would make sense if the deal was structured with a true preferred return. They give value in exchange for value.

However, some GPs will raise their equity split in exchange for a pari passu preferred return to limited partners. Surprisingly, many general partners don’t know what type of preferred return they’re offering. That’s why it’s important to read the private placement memorandum (PPM) document to better know what you’re investing in.

For example, they’ll raise the straight split of 80/20 with no preferred return to a 70/30 split with a 7% pari passu preferred return. Raising GPs equity split from 20% to 30% increases their fees by half. Knowingly or unknowingly, they are taking a massive increase in fees in exchange for very little value to LPs in the pari passu preferred return.

This blog post is an excerpt from my book Passive Wealth. You can check out the book at the link below.

Amazon link