Earlier this week, I stumbled into yet another syndication holy war discussion on Twitter.
RETwit (as it’s affectionately known) was going hard at each other over preferred returns in syndication deal structures. Team Pref was arguing it’s an essential investor protection, with Team No-Pref firing back that it’s just a marketing gimmick.
This is an evergreen debate that seems to surface every few months in our little corner of the investing world. So I want to cut through the noise and talk about what preferred returns actually are, how they work, and why they’re probably not as important as you think.
What Is a Preferred Return?
Put simply, a preferred return is a fixed, annualized rate of return that passive investors (the LPs) receive before the deal sponsor (GPs) takes any profits.
So say you’re looking at a deal with an 80/20 split and a 6% pref. This means the LPs (you) get 80% of profits and the GPs get 20%…but only after you’ve received your 6% preferred return first.
So if the deal generates 10% gross returns in a given year, you get the first 6%, then the remaining 4% gets split 80/20 between you and the sponsor.
The sponsor sees zero cash flow until that 6% hurdle is cleared.
The Biggest Misconception
If you only take away one thing today, let it be this: preferred returns are NOT a guarantee.
A pref simply means you’re first in line to receive cash flow from the deal. It doesn’t guarantee that cash flow will actually exist.
A (possibly bad) analogy is like being at the top of the standby list for a flight. You get the first available seat, but there’s no guarantee that any seats will be open.
The Marketing Angle
So what’s the real reason so many sponsors structure their deals with a pref?
One word: marketing.
A pref often makes deals sound “safer” and more attractive. “You get paid before we do!” the sponsor says, or they’ll compare their 6% pref to 4% T-Bills to justify why your money is working hard in their deal.
But here’s the truth: a preferred return doesn’t change the total returns of a deal…it only changes the timing of distributions.
Read that again. It’s the second most important thing to understand about prefs (after the “not guaranteed” part). A preferred return doesn't manufacture cash flow out of thin air. It doesn’t pump up your returns. It just shifts when you receive the money.
Numbers Don’t Lie
I’ve spent a lot of time over the years analyzing deals and deal structures, comparing returns both with and without prefs. And in most of the cases I’ve studied, the difference in investor IRR over a 5-10 year hold period is less than 50 basis points.
Half a percent. Over a decade.
That’s essentially a rounding error, which underscores my point: the pref doesn’t create wealth, it just moves it around on the timeline.
The Alignment Trap
“But doesn't a pref ensure better LP/GP alignment? The sponsor has to hit that hurdle before they get paid.”
Logically, yes. But in practice, it can backfire.
When a deal struggles and the pref keeps accruing with no end in sight, sponsors lose motivation. They’re human – they’ll refocus their energy on deals that actually have a shot at paying them.
And the already-struggling deal with mounting preferred returns? It gets further neglected.
So much for alignment.
When Prefs Actually Make Sense
I’m not completely anti-pref. There are situations where they work well.
For stable, long-term, cash flow-heavy deals, prefs can make perfect sense.
For example, we offer a 6% preferred return in our private credit fund. But that’s a cash flow-focused, coupon-clipping type of investment. It’s not designed to have massive equity growth on the back end.
Where things get wonky is in value-add deals where most of the returns come from appreciation realized at sale. That’s where the incentive structure can start working against you.
The Bottom Line
Don’t get hung up on whether a deal has a preferred return or not.
If you find yourself comparing Deal A (pref) to Deal B (no pref) and using that as your deciding factor, pause. You’re probably focusing on the wrong thing.
Instead, focus on what actually drives returns: the quality of the deal, the track record of the sponsor, and how conservative their assumptions are. These factors will influence your outcome far more than the presence or absence of a pref.
Remember: there’s nothing inherently bad about a preferred return, but it’s not magic. It doesn’t create money, and it’s not going to make or break your investment.