Preferred Returns, Waterfalls, and Why They Protect You

Most private fund term sheets mention a "preferred return" — sometimes 7%, sometimes 8%, sometimes 6%. But what does it actually mean, and how does it protect you as an LP?

The Basic Concept

A preferred return (or "pref") is a minimum annual return that limited partners must receive before the GP participates in profits. It's not a guaranteed return — it accrues only if the deal generates sufficient cash flow — but it establishes a priority waterfall that puts investor capital first.

How the Waterfall Works

A standard 2-tier waterfall in a real estate fund looks like this:

1. Return of Capital: 100% of distributions go to LPs until they've received their invested capital back.
2. Preferred Return: 100% of distributions go to LPs until they've received the pref (e.g., 8% per year on invested capital) for each year the investment was held.
3. Catch-up: The GP receives a larger share of distributions until they've "caught up" to their promoted interest (typically 20% of profits).
4. Profit split: Remaining distributions split per the agreed ratio (e.g., 80% LP / 20% GP).

Why It Matters

The pref creates alignment. A GP who structures a deal with a strong preferred return and a carried interest that only triggers after the pref is paid has a strong incentive to execute — their upside only exists if yours is protected first.

The alternative — deals with no pref, or pref structures that reset on refinance events — can allow GPs to harvest promote on paper gains while LP capital is still at risk. Read every term sheet carefully.

What Cara Capital Requires

Every deal we bring to our investors must have a GP co-investment, a meaningful preferred return (typically 7–8%), and a waterfall that returns LP capital before any GP promote. We walk away from deals that don't meet this standard, regardless of return projections.

Questions about a specific term sheet? Reply to this email or reach us through the contact page.