Fund raising is an exciting event in the life of a fund and for fund managers. It’s the excitement of building something new or taking it to the next level. Fund raising is also competitive with many types of deal structures to entice potential investors. The most common trend today involves mortgage or debt funds offering a preferred return rather than one solely based on allocable net profit. Accordingly, it’s important to understand the basics of a preferred return.

What are the mechanics of a preferred return?

There are certain questions to consider when it comes to understanding what type of preferred return you should offer.

Is it compounded or non-compounded?

Compounded means the calculation of a preferred return’s periodic growth amount comes from the amount of invested capital plus all previously earned but unpaid preferred return amounts. In our experience, many funds generally offer a compounded return for those investors who elect to reinvest their return.

Is it cumulative or non-cumulative?

Cumulative is when the actual earnings fall short of the preferred return and the shortfall is carried forward to the following period until the cumulative earnings of the fund reach the preferred return. Many funds have this option. In particular, real estate or traditional private equity funds that invest in real estate have this option because the revenue is sporadic or one-time in nature (gains on sales of the assets). It is also to incentivize investors to capture the capital gain treatment upon sale, refinance, and/or other realization event.

On the other hand, non-cumulative means the shortfall of actual earnings does not carry forward to the following period. The preferred returns do not accrue, and the investors are not entitled to any past unearned preferred returns. Non-cumulative preferred returns are common in mortgage funds. Fund sponsors and their attorneys should carefully strategize how to structure preferred returns in accordance with the fund’s business plans.

Can a preferred return be paid when there is no net income?

The short answer is no. By definition, a preferred return is a claim against net profits. If a net profit does not exist, or there is insufficient net profit to meet the preferred return promised to investors, then the preferred return should not be paid. However, if preferred returns are paid to the investor when there is insufficient net profit to pay them, these distributions are either considered returns of capital or guaranteed payments—interest expense. There are tax implications related to guaranteed payments, which are discussed below.

What happens in practice?

In our experience, we have seen certain funds continue to pay out preferred returns even though there is insufficient net profit to pay them. These excess payouts are not profit distributions; rather, they are considered returns of capital or, potentially, guaranteed payments. A return of capital does not carry any tax implications but will reduce the amount of capital upon which the investor can generate future preferred returns. If fund management provides investors with unsolicited returns of capital, it needs to disclose this fact since failure to do so can have securities law implications related to disclosure omissions.

The implications to the fund for paying out returns of capital or guaranteed payments are as follows:

Taxes

If preferred return payments are deemed guaranteed payments that are not based on net profit, they will be considered taxable income to the investor and an expense to the partnership. The tax rules and related case law around this issue are unclear, complicated, and require consultation with legal counsel and the tax CPA performing the tax preparation services and are beyond the scope of this article.

Operations

The fund manager must divert valuable capital resources away from revenue-generating activities as a result of making profit distributions greater than actual profit.
The fund potentially has not complied with the terms of its private placement memorandum, depending on how the preferred return language is structured.

Financing

The fund must perform additional capital raising to replace the excess funds distributed.
The fund will be required to explain to investors, who received returns of capital or guaranteed payments, the effect on their capital account or taxability of the distribution.
Alternative solutions to structure preferred returns
Allocation of Net Profits

Alternative solutions to structure preferred returns

Allocation of Net Profits

Rather than having a preferred return model, allocation of net profit allows the fund to only pay out net profit earned on either a monthly or quarterly basis. This method allows the fund to conserve cash for operating transactions without the burden of determining how much available cash must be set aside or borrowed to pay for preferred returns that may not yet exist. While this strategy is not commonplace, it exists, and funds have still been successful at raising capital.

Accrual of Cumulative Preferred Returns

For any funds that have cumulative preferred returns, the fund manager may accumulate such unearned preferred return as an off-balance sheet obligation. To the extent fund management goes to market with a cumulative preferred return option for prospective investors, the cumulative preferred method allows the fund to acknowledge its commitment while still enabling it to maintain liquidity for operations. This method is commonplace since it enables the fund to have a stipulated preferred return and concurrently conserve operating cash as the need arises.

Management Fee Waiver

This option provides a triggering event for management to waive (not defer) its normal fee for asset management and loan originations, among other fees, in an effort to ensure that required net profit is sufficient to meet preferred return commitments. This method is not normally documented in a fund’s private placement memorandum; however, we have seen fund management periodically waive their fees to meet preferred return requirements.

Debt Raise Instead of Capital Raise

A debt raise is a method that allows the fund to solicit funds through debt rather than capital financing. This method does not diminish the ultimate cash payout. Instead, it categorizes the return on debt as an interest expense rather than a preferred return. To the extent there is insufficient net profit to pay a preferred return, this method allows for the guaranteed payout of funds. This is a suitable alternative for a fund that is interested in paying a fixed return irrespective of the profitability of the fund.

Conclusion

Regardless of the form of profit distribution, investor return is an essential component of capital raising, and there are many alternatives from which to choose. Fund management should consider which capital-raise strategy best meets their needs and the expectations of their investor base.