Q. So we’ve been talking a lot about management fees today… and “preferred return” is one of the most important ideas.
A. Yes, and you see it in many different contexts across different strategies. At its most basic, it says: the manager of the opportunity will not get a share of profits until the investor has received some specified level of profits first. It’s closely related to the idea of a “hurdle rate” but usually also requires that the investor has earned a given rate– compounded annually– over the life of the investment before the manager can take a piece of profits. The term comes from the way cumulative preferred stocks work.
Q. But what about the basic management fees — are those normally paid to the managers prior to the preferred return to investors?
A. Usually but not always. If the investment clearly requires a lot of ongoing management and investment to make it work, then the management fees might go out annually even though no profit has yet been realized. Indeed, sometimes investors have to keep paying out of pocket for these fees, since all the capital has gone into investments.
Q. And I guess from what we’ve heard before, these kinds of fee structures are seen in PE and RE type deals, but not so often in hedge fund land.
A. Right, though, especially in fund of fund situations, hurdles are becoming more common. You see structures like “0 and 10, but only over a 4% return” as a way of overcoming the famous “fund of fees” problem.
Q. Now, this issue also comes up in the distinction between American and European waterfall structures… the issue of deal-by-deal profits vs overall fund profits.
A. Right. With American waterfalls, the manager gets paid on each deal the fund realizes. There can be a preferred return in that— the investors get back the amount invested in that one deal, plus a preferred return, before the managers get paid. The European model is preferable for investors, though: there, the investors have to get back their entire investment in the fund, plus a preferred return, before the manager gets paid.