If you invest in real estate or other businesses that produce steady cash flows, it is more common to see preferred equity enter the stack. This could be hard or soft, but the high level understanding you need to have of it is that the investors have a claim on their equity repayment and usually a preferred return is due before cash is split elsewhere to the GP.
A preferred equity joint venture can be favorable in situations where both parties involved have different goals and risk appetites. Here are some scenarios where a preferred equity joint venture can be beneficial:
- When the parties have different levels of expertise or resources: One party may have the expertise and industry knowledge, while the other has the financial resources to fund the venture. In this case, a preferred equity joint venture can provide a way to share risks and rewards.
- When the parties have different risk tolerances: One party may prefer a fixed return on their investment, while the other may be willing to take on higher risk in exchange for potentially higher returns. A preferred equity joint venture can provide a way to structure the investment to meet both parties' risk tolerance levels. This IRR Hurdle waterfall template is one of the staples in how these deals end up getting structured.
- When the parties have different exit strategies: One party may be interested in a long-term investment, while the other may be looking for a shorter-term exit. A preferred equity joint venture can allow for flexibility in the investment structure, such as a buyout option or a put option, which can meet both parties' objectives.
- When the parties have different capital requirements: One party may require more capital than the other to fund the venture. A preferred equity joint venture can allow for different levels of investment and preferred returns based on each party's capital contribution.
- Strong cash flow: A preferred equity deal is typically structured with a fixed dividend rate. To ensure that the preferred equity investor receives regular payments, the underlying business should have strong and predictable cash flow.
- Limited use of debt: Preferred equity investors usually prefer that the underlying business has limited debt, as debt payments can reduce the cash available for dividend payments. This can also increase the risk of default in the event of a downturn in the business.
- Growth potential: A preferred equity investor typically seeks growth potential in the underlying business. This can be in the form of expanding the customer base, entering new markets, developing new products, or increasing operational efficiencies.
- Experienced management team: A strong management team with a proven track record is important to execute the growth strategy and ensure the success of the underlying business.
- Clear exit strategy: Preferred equity investors typically seek an exit within a defined timeframe, such as 3-7 years. The underlying business should have a clear and realistic exit strategy, such as an IPO, a sale to a strategic buyer, or a buyout by the management team. A REFI may also be used as a source of cash flow.
- Valuation: The valuation of the underlying business should be reasonable and aligned with the growth potential and cash flow of the business. The preferred equity investor should also have a clear understanding of the assumptions and projections used in the valuation.
Overall, a preferred equity joint venture can be a favorable option when both parties can benefit from sharing risks and rewards while accommodating their unique goals and risk appetites.
Be very aware that 'preferred return' is not the same as 'preferred equity'. They are two different things.
