Justification for Investor pref Return
How does an investor land on a pref return % when structuring terms.
Obviously, this can be argued by the sell side banker & target, and often is....
But is there ever any rationale, rules, or discussion within the PE firm as to why an 8% pref return would be more defendable than a 10% pref? or why X is better than Y in a particular situation?
What do Investors normally base their arguments on for arriving at pref %, I can see it potentially being easier to argue if the company was a cash cow as more free cash flow? - Any advice appreciated!
Investors typically justify the preferred return percentage based on several factors, and while there is no universal rule, there are common rationales and considerations that guide the decision:
Market Standards and Expectations: An 8% preferred return is often seen as a standard in the industry, particularly because many institutional investors, like pension funds, require a minimum return of around 8% to meet their funding obligations. This makes it a defendable benchmark.
Risk-Adjusted Return: The preferred return is often tied to the perceived risk of the investment. For a "cash cow" company with strong, predictable free cash flow, a higher preferred return (e.g., 10%) might be justifiable because the risk of not achieving that return is lower. Conversely, for a riskier investment, a lower preferred return might be more appropriate to reflect the uncertainty.
Cost of Capital: The preferred return is often aligned with the investor's cost of capital. If the investor's cost of capital is higher, they may push for a higher preferred return to ensure the investment meets their return thresholds.
Negotiation Dynamics: The preferred return is also a point of negotiation between the PE firm and the target or sell-side banker. A higher preferred return might be used as a bargaining chip to secure other favorable terms in the deal.
Fund Economics and LP Expectations: PE firms consider the expectations of their Limited Partners (LPs). If LPs expect a certain level of return, the preferred return is structured to align with those expectations while ensuring the GP can still achieve carried interest after meeting the hurdle.
Investment Horizon and Exit Strategy: The timeline for realizing returns can influence the preferred return. For longer-term investments, a higher preferred return might be used to compensate for the time value of money.
Cash Flow Characteristics: As you mentioned, a company with strong free cash flow might justify a higher preferred return because the cash flow can support regular distributions, making it easier to meet the hurdle.
In summary, the preferred return percentage is a balance between market norms, risk assessment, negotiation leverage, and alignment with LP expectations. While 8% is a common benchmark, deviations are justified based on the specific circumstances of the deal and the characteristics of the target company.
Sources: LPs/Investor Return Structure, https://www.wallstreetoasis.com/forum/private-equity/thinking-like-an-investor-the-key-financial-metrics?customgpt=1, Public Perception of Private Equity: A Discussion, Real Estate Private Equity Technical Qs, Renewable Energy PE Overview
Assuming you mean for a minority investment (like convertible preferred for VC rounds) or some sort of structured equity investment? 8% is ~1.5x MOIC over 5 years, so that’s a relative benchmark. It’s all based on market precedent, so you’d point to other deals getting done. If you think you have more value to add as an investor, you might be able to have more but you’re competing against other capital.
Ignore the cash flow component. The pref is on equity (so it compounds and gets realized at exit), and if you have a structured equity, you probably aren’t generating any cash.
Thanks! this was vry helpful!
8% is market hurdle rate for most PE/VC funds so represents their minimum cost of capital
Also correcting the above - this isn't only relevant for a minority investment (in fact, it's sometimes considered aggressive to put a PIK on a minority interest that already has preference in the capital stack). It's also relevant to sponsors who invest in a preferred share class to management's equity/grants. Often this preferred equity tranche has a PIK (8 or 10%), per JG, consistent with cost of capital and/or whatever they they they can charge without losing deals or disenchanting management.
Same way you price anything else. Look at rel val in the capital structure, cash flow yields, and growth. How does it like today? How will it look like tomorrow? How does your paper compare to other parts of the capital structure? When you have the answers to that, figure out if it’s a decent risk reward. Done.
To expand on poster above:
if you look at the Rel Val in the capital structure and you see senior secured debt gets a coupon of 8-10% (call it E+4-5%), and you are taking more risk (i.e. your deeper in the capstack and hence in a liquidation would need to wait until the senior secured debt is paid in par before getting any recovery), you would expect to be compensated for that additional risk
Hi,
Just revisiting this - (and thanks for all that previously commented, was very helpful!)
I spoke to my associate yesterday, and he seemed to think that all PE's structured their investments with this structured pref/or convertible loan note structure, so they received a minimum ROI?
Is this true? - I think a few people on here seemed to think this sort of structured equity wasn't common in LBOs?
I'd be keen to hear if there's a difference in the commonality of this structuring between MF/UMM and LMM/SME shops, ie who does it more? And if there is this common difference between US and UK equity investing?
Look forward to hearing your responses. Cheers!
There are two things here. One is a pref from the sponsor structured as a loan note. This is a hurdle for the common equity and management incentive package. This is very common.
The second is a pref from an external partner or from someone themselves which acts as PIK leverage. This is much more uncommon. This is true leverage. That’s separate from the loan notes vs ordinary equity leverage which will still remain the same.
You’re best off talking to a tax advisor if you have access to one to get a teach in if you can. It’s a bit complicated with similar or the same terminology for very different things.
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