IRR Preferred Return 101

The preferred return is a threshold return that limited partners are offered prior to the general partners sharing in the profits from the deal.

For example, if the preferred return is an 8% IRR, the limited partner must receive an 8% IRR (on the investment) before the general partners share in any profits from the deal.

Important: In order for the IRR preferred return hurdle to be met, the limited partner has to receive a full return of capital.

Let’s break down exactly how this happens.


Example 1:

  • LP Investment: $100,000
  • Preferred Return: 8% IRR
  • No return of capital

In this hypothetical investment of $100K, this investor receives some cash flow every year. They have not received their initial investment contribution of $100K back.

Notice that even after receiving cash flow every year, this investor is still far from receiving their preferred return of an 8% IRR.


Example 2:

  • LP Investment: $100,000
  • Preferred Return: 8% IRR
  • Return of capital in Year 5

In this example, the investor receives cash flow distributions every year and a full return of capital from the sale profits.

When the investor receives a full return of capital ($100k), the IRR equals 0%. Then turns positive as more cash is received.

The 8% IRR preferred return is only possible after the initial investment of $100k is returned to the investor (and the cash flow given).


Conclusion

After the LP preferred return is met, the general partners can now share in the remaining profits and earn their promote. But this was only possible after the investor received their promised preferred return.

In most cases, the project will only be able to fully return investor capital at a capital event, i.e. a refinance or sale.

The IRR based preferred return is the most industry accepted method and this is what we use in our underwriting models here at NLFM.