As an investor in private placements, understanding preferred returns is crucial to evaluating the health of an investment. Preferred returns refer to the contractual entitlement to distributions of profit, which are given priority to investors until a predetermined threshold rate of return has been met.
Typically expressed as a percentage of return on an annual basis, preferred returns offer investors a degree of security, as they are given priority over the company’s income before general shareholders. This incentivizes those running the company to work hard to not only meet promised preferred returns but also generate enough excess income to be profitable.
The presence or absence of preferred returns can reveal the intent of your partners in returning your money. Operators who do not offer preferred returns may not have investors’ best interests in mind or may not be as well-capitalized and need the proceeds from cash flow to fund their syndication operations.
As an investor, it is important to understand the significance of preferred returns to ensure that your goals and those of the company are aligned. By checking the rate of preferred return, you can assess the potential return on investment and determine whether an investment opportunity is worth pursuing.
The first type is cumulative versus non-cumulative. When reviewing a private placement memorandum (PPM), it’s important to check if it’s a cumulative preferred return. Choosing a cumulative preferred return is advisable since it protects your overall return.
To understand this better, let’s revisit our earlier example. Suppose you’re given a preferred return of 8% per annum. In a non-cumulative preferred return, if you receive only 6% in year one instead of the anticipated 8%, you lose the difference. With a non-cumulative return, you forfeit the right to receive the difference after the year ends. The preferred return resets every year and does not carry forward.
A cumulative preferred return, on the other hand, allows you to add the difference and roll it over to the next year. So, if you receive only 6% in year one, your preferred return for the following year would increase to 10% (8% + 2%).
In a normal business cycle, cash flows are expected to increase annually as operations stabilize and become more profitable. Although the percentage of the promised return remains fixed, the actual value of the return increases as the number it’s computed from also increases over the years. As a result, you can get a return on your investment sooner.
It’s important to always read your investment documents carefully to ensure that you are investing in projects with a cumulative preferred return.
Another type of preferred return is the preferred return with catch-up. This type is the second position in the waterfall distribution schedule. In this scenario, once your share of the profit is achieved and set aside, the operator receives all or most of the profits until the operator “catches up” and reaches the same portion of equity you received. This catch-up provision enables the operator to receive its entire equity split as initially agreed by both parties.
It’s important to understand the distinction between preferred returns and preferred equity when reviewing PPMs. In the investment life cycle, after funding is secured, your investment can be structured as either preferred returns, preferred equity, or a combination of both. We’ve already discussed how preferred returns work – they prioritize a fixed return on investment without considering the actual return of your overall capital.
With preferred equity, you’re given priority treatment to receive your returns during the holding period and also have a higher chance of receiving back your initial investment when the asset is sold. This can be an attractive option for investors looking to mitigate risk.
To balance risk and reward, it’s recommended to consider a mix of preferred equity and preferred returns in your investment portfolio. Preferred returns can provide a steady and consistent cash flow, while preferred equity can ensure a return on investment and priority in recouping initial capital.
It’s essential to understand the duration of preferred returns as an investor in private placement memorandums (PPMs). Generally, preferred returns are calculated based on the amount of capital you contributed, multiplied by the promised interest rate. However, some distribution structures deduct your payouts from your initial capital. As a result, every payment you receive will decrease your unreturned capital, leading to smaller payouts over time. While some operators prefer this structure to achieve profitability more quickly, it results in your preferred returns gradually diminishing.
Operators may suggest that this structure is beneficial because you don’t pay taxes on the cash flow. However, it’s better to choose preferred returns distributed from profits alone and not deducted from your initial capital as an investor. This ensures that your payouts will not be diminished, and you won’t have to worry about taxes at the moment. Depreciation each year should offset all the distributions you receive.
It’s worth noting that preferred returns are not the most efficient way to get back your initial capital. Usually, you need to go through a capital event such as a refinance or supplemental loan to reduce your unreturned capital contributions or get your capital back completely. Through these events, you would receive a portion of your initial capital back, reducing your unreturned capital contributions.
For instance, suppose you invested $100,000 with an 8% preferred return rate, which means you would receive $8,000 per year. Instead of deducting this amount from the initial capital, it’s treated as a dividend gain. In year three, when the operations have stabilized, and the company is due for refinancing, you could lobby to get a portion of your capital back. Your preferred return rate would then be based on the remaining unpaid capital. If you were to receive $40,000 during the refinancing, you would still enjoy an 8% preferred return rate on the remaining $60,000.
However, it’s important to note that reducing your unreturned capital does not diminish your equity position in the overall deal. The amount is only used to calculate your preferred returns. Still, some operators may reduce your equity position during a refinance or supplemental loan. As an investor, it’s crucial to read the PPM carefully and understand the terms before investing.
In conclusion, investing in private placements can be a great way to diversify your portfolio and potentially earn higher returns. However, it is important to approach these investments with caution and do your due diligence before committing your capital. Preferred returns can be a valuable tool to protect your investment and ensure that you receive a steady stream of income. By understanding the difference between preferred returns and preferred equity, as well as the distribution structures that impact payouts, you can make informed decisions when investing in private placements. Remember to prioritize the protection of your capital and carefully weigh the risks and potential gains before making any investment decisions.
