🛠️ Investment Fund Key Terms, Part 16

🎉 Happy Friday, funds family!

Today, we have Part 16 in our many-part series walking through each term in an investment fund term sheet in detail.

Here’s the index of each article in this series (so far):

• Part 1: Naming your entities

• Part 2: Investment objectives

• Part 3: Fund size

• Part 4: LP minimum check size

• Part 5: GP commitment

• Part 6: Fund term

• Part 7: Fundraising period

• Part 8: Investment period

• Part 9: Capital recycling

• Part 10: Investment limitations

• Part 11: Leverage Limitations

• Part 12: LP Withdrawals

• Part 13: Key Person Event

• Part 14: Successor Funds

• Part 15: Carried Interest

This week focuses on Preferred Returns. 

An investment fund or syndication’s preferred return (“pref,” “hurdle,” or “priority return”) is one of the most misunderstood concepts in fund formation.

The preferred return is NOT a guaranteed dividend. It’s simply the LP’s minimum annualized return before the GP can participate in carry.

➡️ What is a Preferred Return?

At its core, a preferred return is a priority yield on contributed capital. Philosophically, the idea is that the GP shouldn’t earn carry unless LPs have received a baseline return. Otherwise, why not just invest in the S&P500?

Whether it’s 8%, 6%, simple, compounded, or non-compounded depends entirely on the strategy and market norms. The economic effect, though, is the same: LPs get paid a little extra (on top of a return of capital) before the GP gets carried interest. 

➡️ Key Components of a Preferred Return

Here are the main variables you’ll see in the wild (and the ones you negotiate constantly): 

🔸Rate: Common rates are between 6-12%, but can be higher or lower depending on the asset class. Riskier strategies usually have higher preferred returns. 
🔸Compounding: Is the pref compounded annually or non-compounded (simple)? 
🔸Ordering: Is the pref the first step in the waterfall, or is it the second step in the waterfall after the “return of capital” step? 
🔸Accrual timing: When does the pref “clock” start ticking? Most common is when the capital hits the fund or syndication’s bank account from the LP’s bank account. 

The above are just examples. In the wild, you’ll find all sorts of splits, percentages, and structures. 

➡️ Simple Example

Here’s the kind of simplified illustration LPs love:

🔸LP invests $1,000,000
🔸Pref = 8% simple
🔸After two years, LPs must first receive $160,000 in preferred return + return of the original $1,000,000

Only then does the GP become eligible to earn carried interest. 

➡️ Venture Capital

VC funds are a little different than other asset classes – they almost never have a preferred return!  

🗓️ Next up in Part 17: GP Catch-Up Provisions

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.