Pari passu preferred return

I'm new to real estate waterfalls, so I've been googling the terms and "pari passu preferred return" seems to be a standard term that is used.  But is it technically a nonsensical term? 

From google, "A preferred return is a profit distribution preference whereby profits, either from operations, sale, or refinance, are distributed to one class of equity before another until a certain rate of return on the initial investment is reached."

Meanwhile, "pari passu" is "a Latin phrase meaning "equal footing." In finance, "equal footing" means that two or more parties to a financial contract or claim are all treated the same"

And "pari passu preferred return" is when "the investor and the sponsor receive the same preferred return at the same time."

If the sponsor and investor are receiving the same return at the same time, then it seems to me that the return is no longer "preferred" in any way.  Shouldn't it be called something else, like just "pari passu return"  Am I missing something?

 
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The equal footing in Pari Passu refers to claim on collateral in the setting of default whereas preferred equity gets payment priority like in dividends

These terms have different meanings in the context of real estate private equity.  I think you're thinking of how they're used outside real estate.

 

I've been doing some more reading, and I think I might have the answer to my own question.  I think both the "true pref" and the "pari passu pref" are still both considered preferred return, because they are both still preferred over the promote.

 

I think it's easier than that (more than happy to be corrected if wrong).

Hypothetical deal with dummy numbers:

£2,000 deal - £1,000 Eq -£1,000 Debt

Eq Contributions: LP 90% - GP 10%

LP: £900 Eq

GP: £100 Eq

"Simple" Preferred return:

Until we reach 10% IRR, there is a simple preferred return. 10% represents £100 -> LP is getting £100 (we're not taking contributions into account)

Let's say we're facing a pari passu preferred return:


Until we reach 10% IRR: There is a preferred return + Pari Pasu

(Imagine this distribution represents £100) - LP gets £90 GP gets £10.

What I'm trying to articulate is that it will "always" be a preferred return (based on the fact that there are hurdles and set-up percentage for the LP/GP split and hurdles) BUT if it's pari pasu, the GP is also getting something AT THE SAME TIME OF THE LP (based on its contribution).

Hope it was clear ahah (then comes the nice stories of catch-ups)

 
Most Helpful

Pari passu in the context of a waterfall means the LP and GP each receive their proportion of cash flow based on the equity they contributed e.g. GP put up 5% equity so GP receives 5% of cash flows; LP put up the remaining 95% so the LP receives 95% of cash flows. 

This structure occurs until the preferred return is hit. From then on further hurdles will not be pari passu as there will be a promote to the GP which will mean the GP will receive an outsized proportion of cash flows. For example if there is a 20% promote in Hurdle 1, the GP will receive 20% of total cash flows plus 5% (GP's initial equity contribution) of the remaining 80% of cash flows left over. So, the GP will not be receiving a flat 20% of cash flows but 20% + (5% x 80%) = 24%. I found this concept tricky to understand initially but reading and modelling it out will help.

Example:

Pref return up to 8% IRR - GP receives 5% of cash flow; LP received 95% 

Hurdle 1 cash flows above 8% IRR - GP receives 20% promote i.e. 24% of remaining cash flow and LP receives 76% of remaining cash flow

 
Flower21

Pari passu in the context of a waterfall means the LP and GP each receive their proportion of cash flow based on the equity they contributed e.g. GP put up 5% equity so GP receives 5% of cash flows; LP put up the remaining 95% so the LP receives 95% of cash flows. 

This structure occurs until the preferred return is hit. From then on further hurdles will not be pari passu as there will be a promote to the GP which will mean the GP will receive an outsized proportion of cash flows. For example if there is a 20% promote in Hurdle 1, the GP will receive 20% of total cash flows plus 5% (GP's initial equity contribution) of the remaining 80% of cash flows left over. So, the GP will not be receiving a flat 20% of cash flows but 20% + (5% x 80%) = 24%. I found this concept tricky to understand initially but reading and modelling it out will help.

Example:

Pref return up to 8% IRR - GP receives 5% of cash flow; LP received 95% 

Hurdle 1 cash flows above 8% IRR - GP receives 20% promote i.e. 24% of remaining cash flow and LP receives 76% of remaining cash flow

It is also worth noting that you can structure the waterfall so that returns are explicitly not pari passu.  It's not exactly common, but strong Sponsors can sometimes demand a catch up on their promote, which explicitly negates the concept of pari passu returns.

Example: GP invests 10% of the equity, LP 90%

Pari passu:

#1: All cash flows equally to the partners, 90/10, until they've both gotten a return of all their capital

#2: Remaining cash flows equally to the partners until they have both received an [8%] return on their capital (make up the number, it doesn't matter in this context)

#3: Every dollar after that hurdle has been hit, the GP receives 20% of

Catch up scenario:

#1: Same

#2: Same

#3: The GP receives 100% of the cash until their distributions (not including the pref return on their equity investment) equal 20% of all cash distributed

#4: GP receives 20% of every dollar distributed thereafter

As you can see, that extra step is extremely beneficial to the GP.  It also means that dollars are not flowing pari passu, even within the context of the promote structure, as the GP is receiving preferential distributions compared to the LPs in Step #3

 

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