The Illusion of Preferred Returns: Why Deals Without Them Can Be Just as Attractive

When evaluating investment opportunities, one term that frequently pops up is the “preferred return.” In simple terms, a preferred return guarantees that investors receive a certain percentage of profit—typically ranging from 6-8%—before any profit is shared with the sponsor or general partner. It’s marketed as a form of protection, ensuring that limited partners get paid first. While this concept may sound appealing at first glance, the reality is far more nuanced. Deals without a preferred return can be just as attractive—if not more so—than those that offer one.

Preferred Returns Are Meaningless Without Profits

One of the biggest misconceptions about preferred returns is that they automatically signal a safer or better deal. However, if the deal doesn’t generate profits, no preferred return will be paid. In fact, preferred returns are entirely contingent upon the performance of the investment. If a deal underperforms, the preferred return is nothing more than an empty promise. In such cases, it offers no actual protection to investors.

Conversely, deals that don't offer a preferred return but have strong fundamentals may still generate healthy cash flows and provide better long-term returns. The absence of a preferred return doesn’t necessarily equate to higher risk or a less profitable opportunity.

Preferred Returns Don't Guarantee Superior Metrics

Just because a deal includes a preferred return doesn’t mean it’s inherently superior. Investors should pay more attention to the overall deal metrics: projected returns, internal rate of return (IRR), equity multiple, and risk profile. A deal with strong metrics, even without a preferred return, can outshine a deal that promises a preferred return but has weaker projections. For example, a deal with a preferred return but higher fees or a lower profit split for investors might offer worse outcomes than a deal without a preferred return but with more favorable terms overall.

Preferred returns can sometimes distract investors from more critical factors like long-term profitability, cash flow projections, or the sponsor’s track record. Focusing solely on preferred returns is like judging a car by the paint job rather than the engine’s performance.

Preferred Returns as a Marketing Gimmick

There’s a strong argument that preferred returns are often a marketing tactic, designed to make a deal appear more investor-friendly without truly improving its fundamentals. It’s a psychological play, meant to reassure investors that their capital will be prioritized. But the reality is that the presence of a preferred return is no guarantee of success.

At Fast FIRE Capital, we’ve seen this firsthand. One of our recent deals with Sage Investment Group doesn’t offer a preferred return, yet it consistently delivers a 6% return to investors—reliable and steady, without the fanfare of a "preferred" structure. This kind of consistency is far more valuable than a hollow promise of preferred returns that may never materialize. The focus should be on performance, not perception.

Consistent Returns Speak Louder Than Preferred Returns

Deals without preferred returns can still offer consistent returns, as demonstrated by many high-performing investments in the market. Investors sometimes mistakenly believe that a preferred return makes a deal safer, but consistent cash flow and proven performance are much more reliable indicators of a deal’s success.

Preferred returns may be dressed up as a form of security, but they often don’t offer any real protection. They don’t magically make a deal better if the fundamentals aren’t strong. When assessing an investment, it’s crucial to look beyond the preferred return and instead evaluate the deal holistically. Ask the real questions: Is the sponsor experienced? Is the business plan solid? Are the cash flow projections realistic?

Conclusion: Look Beyond the Smoke and Mirrors

In the world of investing, preferred returns are often given too much weight. While they might sound like a safety net, they’re often nothing more than smoke and mirrors. A deal without a preferred return can offer just as much—if not more—value, as long as the fundamentals are strong. Investors should be wary of focusing too much on this one metric and instead concentrate on the overall health of the deal. Preferred returns may be marketed as a benefit, but in reality, they don’t guarantee success, and often, deals without them can prove to be the better choice.

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