Preferred Equity vs Preferred Return - Comprehensive Explanation

 Preferred equity refers to a class of ownership in a company that gives certain privileges and preferences to the shareholders holding such equity. Preferred equity holders have a higher claim on the company's assets and earnings compared to common equity holders in the event of liquidation or distribution of profits. A preferred return can fit inside a deal that has preferred equity or a preferred return could be the only aspect of a deal. I've seen this type of financing used for investors in many businesses (not just real estate).

Relevant Templates:

Here are some key characteristics of preferred equity:

  • Priority in Distribution: Preferred equity holders have a priority right to receive dividends or distributions before common equity holders. These dividends are typically fixed or calculated based on a predetermined rate or formula.
  • Fixed Dividend Rate: Preferred equity often carries a fixed dividend rate, which means that the shareholders receive a specific percentage of their initial investment as dividends. This fixed rate provides stability and predictability to preferred equity holders.
  • Limited Voting Rights: In many cases, preferred equity holders have limited or no voting rights. They may not have a say in the company's management or decision-making processes, unlike common equity holders.
  • Limited Upside Participation: While preferred equity holders have a higher claim on assets and earnings, they may have limited participation in the company's upside potential. In other words, they may not benefit from significant increases in the company's value beyond the fixed dividend rate.

Preferred Return, on the other hand, is a concept commonly used in the context of real estate investments, private equity, or venture capital funds. It refers to the priority distribution of profits or cash flow to certain investors or partners before other participants receive their share. A preferred return is similar to a preferred dividend in preferred equity.

Here's how preferred return works:

  • Priority Distribution: Investors with a preferred return entitlement receive a specified percentage of the invested capital or profits before other participants receive their share. The preferred return acts as a minimum rate of return that the investors expect to receive.
  • Cumulative or Non-Cumulative: Preferred return can be cumulative or non-cumulative. In cumulative preferred return, if the expected return is not achieved in a particular period, the unpaid amount accumulates and needs to be fulfilled before other participants receive their share. In non-cumulative preferred return, any unpaid amount does not carry over to subsequent periods. When building a financial model template for this, I consider such things as dropdown options so the user can easily understand various scenarios and deal terms.

Preferred equity and preferred return are interconnected in the sense that preferred equity holders often receive preferred returns. Preferred equity holders are entitled to receive fixed dividends or distributions (preferred return) before common equity holders. The preferred return is a mechanism that ensures the preferred equity holders receive a minimum rate of return on their investment. In this way, the preferred return is a way of fulfilling the preferred equity holders' entitlement to a fixed dividend or distribution.

It's worth noting that the terms and conditions of preferred equity and preferred return can vary based on the specific agreements and arrangements between the investors and the company or fund. It is important to carefully review the governing documents and legal agreements to understand the exact rights, privileges, and obligations associated with preferred equity and preferred return in a given context.

Article found in Joint Venture.