What is preferred equity and how does it work?
Short answer
Preferred equity sits in a deal's capital stack between the bank loan and the common equity. Investors in it are often paid before the sponsor and common investors, frequently at a stated return. That order of payment is the cushion. It helps if a deal struggles, but it still depends on the sponsor and on the documents. Many investors talk to a securities attorney about the terms.
Where preferred equity sits in the deal
Think of a deal as a stack of money. Debt is on the bottom and gets paid first. Common equity is on top and gets paid last. Preferred equity sits in the middle.
In general, preferred equity holders are paid before the common owners, often at a fixed rate. Rights can vary a lot from deal to deal, and many people talk to a securities attorney about the documents.
Preferred equity and preferred return are not the same thing
People mix these up. Preferred equity is the position in the stack. A preferred return is the payment that position usually earns before anyone else shares in profit.
On one of our webinars, a guest explained the numbers simply. The person who puts in the money will usually want a preferred return, paid based on the time their money is deployed.
This clip explains the preferred return and the promote, with an 8 percent example on a mixed use project.
His example was 8 percent on a mixed use project. That is $80,000 a year for every million invested. What is left over after that is the back end profit, which is the promote.
The cushion, and where it can fail
On an investor panel, one speaker said most of their investments for about 10 years came through preferred equity. The reason was simple.
Then they shared what they learned. The syndicators they backed had collected their fees up front, and the money in the deal was no longer really theirs. Those sponsors were more willing to walk away from a project. A cushion does not help much if the person running the deal stops protecting it.
Hear the panelist describe how preferred equity worked in practice and what went wrong with some sponsors.
Summary and key takeaways from this video
I take that as a plain lesson. The position in the stack matters, but so does who is running the deal and how much of their own money is at risk.
A high preferred return can change who wins
In our joint venture webinar, a guest told the story of his first co-GP deal. The capital partner set a high preferred return because it was their first deal together. Then, instead of a typical waterfall split, the guest got 100 percent of the promote after the preferred return.
The partner did that to reduce his own risk. The deal ended up at a 78 percent IRR. The guest said he made about twice what the partner made, even though the partner put in all the money and signed on the debt.
Here the guest walks through that first co-GP deal and how the preferred return and promote played out.
The point is that a preferred position often gives steadier, more predictable returns. It can also give up much of the upside. Both sides should understand that before they commit.
What I have said on this at our events
I have seen the structure itself protect people. In one real estate case, we set the deal up as preferred equity, and it helped the earlier investors avoid being wiped out. In that case, the preferred position helped them get money back, though no outcome is assured. Results depend on the property and the documents.
"We've had other cases where knowing how to structure the deal as a preferred equity deal in real estate saved all the investors from getting wiped out. If it wasn't for that structure, none of the investors would have any equity left, and now they'll probably get all their money back."
"Acquire it with preferred equity, so that the previous investors would not get wiped out. But because of that, even if it was completely empty, and we sold it, we would get our money back, because it's a Pref equity deal, and it has great potential."
Facts from this talk
- An 8 percent preferred return on a mixed use project pays $80,000 a year for every $1 million invested, according to the webinar example.
- One panelist said most of their investments for about 10 years came through preferred equity, used to give a cushion if things went wrong.
- A co-GP deal with a high preferred return and 100 percent of the promote after it ended up at a 78 percent IRR.
Sources
From Richard C. Wilson's Centimillionaire Strategies YouTube channel: Joint Venture & Co-GP Webinar - How to Close Deals with Peers & Partners in the Family Office Club, AI, Real Estate & Risk: Lessons from Billion-Dollar Deals | Investor Panel Highlights, Joint Venture & Co-GP Webinar - How to Close Deals with Peers & Partners in the Family Office Club. Quotes come from the video captions, lightly edited for readability. Figures are the speakers' own estimates and experience.
General education only. Not legal, tax or investment advice.
Talk to a securities attorney to explore options around preferred equity terms, operating agreement rights and offering documents. Do not use AI to write your own legal agreements.
Where to start
- Ask where the preferred equity sits relative to the senior loan and the common equity.
- Read how the preferred return is calculated, whether it is paid current or accrues, and what happens if it is missed.
- Look at how much of their own money the sponsor has in the deal and how they were paid up front.
- Ask what rights investors may have if the deal goes wrong, such as approval rights or the ability to step in.
- Many investors talk to a securities attorney about the documents before committing.
More questions on this
Is preferred equity the same as debt?
It is generally described as equity rather than debt, and it is often discussed as sitting behind the senior loan and ahead of common equity. Specific rights vary by deal, so many people talk to a securities attorney about the documents.
What is a promote?
A guest on our webinar called it the back end of the deal, the profit left after the investor gets their preferred return. How it is split is negotiated between the partners.
Does preferred equity protect me if a deal fails?
It can help because you are paid ahead of common equity. It does not guarantee anything, and one panelist found that some sponsors were willing to walk away from a project.
Related questions
- How does revenue-based financing work for growing companies?Revenue-based financing gives a company capital in exchange for a share of its sales until the investor is repaid.
- How does a distribution waterfall work?A distribution waterfall is the order in which a deal pays out cash.
- How do I structure an earnout in an acquisition?Tie part of the purchase price to how the business performs after closing.
- What is a most favored nation clause for investors?A most favored nation clause, or MFN, says that if the sponsor gives another investor better terms, you can ask for those terms too.
Work through it with the how much to raise calculator. See all deal structuring resources.