The simplest preferred return joint venture structure is a partnership agreement between two parties where one party provides the funding for a project or investment, and the other party provides the expertise and management. The funding partner is entitled to receive a preferred return on their investment before any profits are distributed to the management partner.
Simple Preferred Return Waterfall Templates
- Preferred Return (single hurdle rate) (compounding option)
- Preferred Return (multiple hurdle rates) (non-compounding)
The preferred return is typically a fixed percentage rate of return on the investment, and is paid out to the funding partner annually or at the end of the investment period. The management partner receives a share of the profits above and beyond the preferred return, typically in proportion to their ownership stake in the joint venture or at some promoted rate.
This structure is commonly used in real estate investments, where one partner provides the funding for a development project, and the other partner manages the construction, leasing, and operation of the property. The funding partner receives a preferred return on their investment, and the management partner receives a share of the profits once the preferred return has been paid.
The most common way to structure a preferred return is as a fixed percentage rate of return on the investment. Typically, the preferred return is set at a rate that is competitive with similar investments in the market, such as a fixed income investment like a bond or a CD.
For example, if the preferred return is set at 8%, the funding partner is entitled to receive 8% of their initial investment before any profits are distributed to the management partner. This means that if the investment generates a 10% return, the funding partner would receive 8% of their investment, and the management partner would receive 2% of the profits.
The preferred return may be paid out annually or at the end of the investment period, depending on the terms of the joint venture agreement. In some cases, the preferred return may be cumulative, meaning that if the investment does not generate enough profits to cover the preferred return in a given year, the unpaid amount accrues and must be paid out in future years before any profits are distributed to the management partner.
Calculating a Preferred Return if Contributions Happen Throughout the Year:
If contributions happen in the middle of a given year and the preferred return is paid annually, the calculation of interest on the preferred return can be prorated based on the number of days the investment was held during the year.
For example, let's say a funding partner invests $100,000 in a joint venture on June 1st, and the preferred return is set at 8% per year, paid out annually. The investment generates a 10% return for the year, and the preferred return is paid out at the end of the year.
To calculate the funding partner's preferred return for the year, we can prorate the interest based on the number of days the investment was held. Since the investment was held for 214 days (from June 1st to December 31st), we can calculate the preferred return as follows:
Preferred return = ($100,000 x 8% x 214/365) = $3,947.95
This means that the funding partner would receive a preferred return of $3,947.95 at the end of the year, before any profits are distributed to the management partner. The remaining profits (in this case, $6,052.05) would be split between the funding partner and the management partner according to the terms of the joint venture agreement.
Article found in Joint Venture.
