What Does Preferred Return Mean?
The preferred return or "hurdle rate" is a term used in the private equity (PE) world. It refers to the threshold return that the limited partners of a private equity fund must receive, prior to the PE firm receiving its carried interest or "carry." Usually, private equity funds are set up as general partnerships with the PE firm acting as the general partners and the investors as limited partners. The PE firm typically gets remunerated on a 20 and 20 fee structure, with the 20 referring to the percentage of the return in excess of the preferred threshold that the PE firm gets to keep.
Divestopedia Explains Preferred Return
The preferred return has traditionally been set at 8–10%. However, with the significant increase of private equity firms competing for capital, limited partners are demanding different compensation models that either change the 2 and 20 format (sometimes reducing the management fee from 2%, the carry from 20%, or both) or alternatively increasing the preferred return threshold beyond the traditional 8–10%. This is particularly the case for newer, unproven private equity firms that don't have the track record.
While the preferred return of 8–10% is meant to compensate the investors for the longer term hold and iliquidity of the investment, good PE firms that are able to continually raise funds are expected to deliver returns in excess of 20%. It is understood that the iliquidity and risk inherent in private company investments requires returns north of 20, even though the preferred return is typically set at a much lower level. PE firms that consistently cannot deliver above the preferred return not only get a much smaller carry, but also have a tendency to disappear over time because they can't compete with other firms' returns and can't attract capital to raise additional funds.