Preferred Return Mechanics

Preferred Return Mechanics define how the fund calculates and applies the preferred return (hurdle) that LPs receive before carry is paid to the GP. While often described as “8% pref,” the real economics depend on details: compounding, timing, whether it’s paid on contributed capital or unreturned capital, and how it interacts with recycling and distributions.

From an allocator perspective, preferred return is an alignment tool only when it is clear, consistent, and paired with enforceable waterfall protections.

How allocators define pref risk drivers

Allocators evaluate pref mechanics through:

• Calculation base: contributed, invested, or unreturned capital
• Compounding: simple vs compounded and at what frequency
• Accrual timing: when it starts and stops, and how it’s tracked
• Catch-up design: how quickly GP catches up after pref is met
• Interaction with recycling: whether reinvested capital changes pref accrual
• Waterfall consistency: European vs American implications
• Transparency: reporting clarity and auditability

Allocator framing:
“Is the pref a real hurdle that protects LP economics—or a headline number diluted by mechanics?”

Where pref mechanics matter most

• funds with early distributions and long tails
• strategies using recycling aggressively
• funds with complex waterfalls and side letter variations
• LPs that require high governance defensibility

How pref mechanics change outcomes

Strong pref mechanics:

• improves LP protection and alignment narrative
• reduces disputes on carry activation
• increases IC comfort and re-up likelihood

Weak pref mechanics:

• turns the pref into optics rather than protection
• creates confusion in reporting and distributions
• increases side letter demands and legal friction
• raises clawback risk depending on waterfall structure

How allocators evaluate discipline

Conviction increases when:

• pref terms are clear, consistent, and documented across materials
• reporting shows accrual and application transparently
• catch-up is rational and not engineered for early carry extraction
• recycling interaction is bounded and explained

What slows allocator decision-making

• vague language on calculation base and compounding
• catch-up structures that feel overly aggressive
• inconsistent pref application across vehicles or side letters
• inability to explain pref economics with examples

Common misconceptions

• “8% pref is standard” → the mechanics determine real economics.
• “Pref protects LPs automatically” → only if the waterfall enforces it.
• “Catch-up is always the same” → small tweaks materially change GP timing.

Key allocator questions during diligence

• What is the pref calculated on (unreturned capital vs contributions)?
• Is it compounded, and how often?
• When does it accrue and how is it reported?
• How does catch-up work and what is the GP timing impact?
• How does recycling affect pref accrual and carry activation?