Preferred returns are a commonly used form of return in private equity
investment. Generally, a preferred return is a hurdle rate, usually set
between six to ten percent annual return before any carried interest or
income distributions are paid to investors. Preferred returns can be structured
in a variety of ways, but they are commonly used as a means to provide
investors compensation in exchange for the longer term investment and
lack of liquidity associated with private equity investment.
The most common structure for mortgage funds is to offer a preferred return
between six and ten percent at an annualized rate, payable on a monthly
basis. This coincides with the fund’s monthly interest income, and
provides investors a consistent rate of return, as long as the fund is
performing well and meets or exceeds the hurdle rate. Preferred returns
are often paid after expenses, fees and operating costs, including fees
to the management company. Although the structure of a preferred return
is relatively straightforward, they are often a source of confusion in practice.
One common source of confusion is the following: what happens when the
fund exceeds the hurdle rate one month but falls short the next? What
is the fund’s obligation if this happens?
Absent any claw forward or claw back provisions in the offering documents,
the mortgage fund would simply pay the established preferred return the
month it exceeds the hurdle rate, and pay whatever it can in the following
month it falls short. In addition, if the fund had posted a substantial
loss in the second month, the loss may be large enough such that Members
may have received too large a distribution of preferred return during
the first month; in such a case, there is no mechanism for the fund to
necessarily claw-back or recall excess distributions already made to investors
during the earlier part of the fiscal year.
For these reasons, fund managers must carefully model their fund’s
preferred returns to fit their income structure. For funds whose business
models are designed for consistent periodic income, such as mortgage funds,
the preferred return must be carefully modeled to fit their financial
Another source of confusion for some fund managers is the obligation tied
to the preferred return. A preferred return is fundamentally a priority
payment prior to any income distributions to the fund’s investors
and/or the management company. It is not a guarantee or any type of fixed
obligation on the fund manager’s part. However, if a mortgage fund’s
offering documents are not drafted in a way to ensure that the fund is
adequately insulated from issuing a preferred return when it lacks the
proceeds, investors may misunderstand this preferred return to be an obligatory
periodic payment, causing investor dissension and disputes.
For these reasons, fund managers must ensure that their offering documents
clearly and explicitly explain the nature of the preferred return to its
investors, particularly if they are admitting non-accredited investors.
For more information, or a consultation on private equity offerings, please contact:
KEVIN KIM, ESQ.
Senior Corporate and Securities Attorney
Geraci Law Firm
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