Preferred return
Also called Hurdle rate, Pref
A preferred return is a threshold rate of return that investors in a fund are entitled to receive out of distributions before the manager takes any share of the profits. It sets the order in which money is paid out; it does not promise that the money will be there.
A preferred return is a priority, not a payment. It determines who gets paid first when a fund distributes cash. Investors receive distributions up to the preferred rate before the manager participates in profits at all. If the fund does not generate enough cash, the preferred return is simply not paid, and depending on the terms it may or may not accrue for later.
The distinction that matters most is compounding. A non-compounding preferred return is calculated on the original capital each period. A compounding one is calculated on capital plus any unpaid preferred return, so an unpaid year increases the base for the next. Non-compounding is more common in smaller closed-ended funds and is less favourable to investors over a long shortfall.
A preferred return is frequently confused with a coupon on a bond. A bond coupon is a contractual obligation of the issuer and its non-payment is a default. A preferred return is a distribution priority inside a partnership agreement, and its non-payment is not a default. That difference is the whole risk story.
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