Define a preferred return in an equity waterfall and its effect on distributions.

• A. A preferred return guarantees a minimum annual return to investors before common equity profits are shared
• B. A preferred return is a fixed percentage of total profits shared equally
• C. A preferred return is a loan-like obligation repaid before profits
• D. A preferred return is a tax deduction used for sponsors

Answer: (A)

A preferred return creates a priority on distributions by guaranteeing investors a minimum return on their invested capital before any profits are shared with the sponsors or common equity. It’s usually expressed as a percentage of contributed capital and can accrue if not paid in a given period, meaning unpaid amounts build up to be paid later. The effect in the distribution waterfall is that all available cash flow first goes to satisfy this hurdle for the investors. Only after the preferred return hurdle is met do remaining profits flow to the sponsors or be allocated according to the agreed split, sometimes with a catch-up phase that lets sponsors catch up after the hurdle is satisfied. This structure protects investors and ensures they receive a minimum, priority return before upside is shared with others.