A preferred equity deal lets an LP raise cash without selling at a discount. It keeps the upside and, less visibly, all of the downside.
In a preferred equity secondary, an investor advances cash against a portfolio of LP interests and takes all of its distributions until it has earned a priority return, then a share of what follows. On an illustrative 100 of NAV, 30 of pref at 12 per cent with a 10 per cent kicker is worth 91.47 to the seller against an 85 outright sale, and earns the investor 25.5 per cent. If the portfolio disappoints, the same deal is worth 61.44 to the seller while the investor still earns 17.2 per cent.
Worked in full in The Private Equity Secondaries Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Preferred equity is the structured alternative to selling an LP portfolio at a discount. The seller raises cash now, avoids printing a discount, and keeps the long-term upside. The price is not a discount to NAV but a waterfall, and a waterfall has to be run on cash flows before anyone can say whether it is cheaper than a sale. This is the LP-led version, where the seller is an investor in the funds; when a fund itself raises pref against its portfolio, the alternative is a NAV loan rather than a sale, compared in NAV loan vs preferred equity.
| Input | Value |
|---|---|
| Portfolio NAV | 100.0 |
| Outright sale price (85% of NAV) | 85.0 |
| Preferred equity advanced (30% of NAV) | 30.0 |
| Priority return, compounding annually | 12% |
| Kicker: pref share of distributions once repaid | 10% |
| Seller's discount rate for retained cash | 10% |
| Base distributions, years 1 to 5 | 20, 30, 35, 30, 15 |
| Stress distributions, years 1 to 5 | 8, 16, 24, 24, 18 |
Base distributions total 130.0, stress distributions 90.0. Neither case has unfunded commitments, so the waterfall only divides cash coming out.
Pref balancet = balancet−1 × 1.12 − priority paidt
Priority paid = MIN(distribution, balance); once the balance is nil, pref takes 10% and the seller 90%
In Excel, with distributions in C4:G4 and the opening balance in B6: grown balance =B6*1.12, priority =MIN(C4,C5), kicker =IF(C5-C7<=0,(C4-C7)*0.1,0), seller =C4-C7-C8, then =NPV(10%,C9:G9) for the seller's retained value.
| Year | Distribution | Priority to pref | Kicker | Pref balance | To seller |
|---|---|---|---|---|---|
| 1 | 20.0 | 20.00 | 0.00 | 13.60 | 0.00 |
| 2 | 30.0 | 15.23 | 1.48 | 0.00 | 13.29 |
| 3 | 35.0 | 0.00 | 3.50 | 0.00 | 31.50 |
| 4 | 30.0 | 0.00 | 3.00 | 0.00 | 27.00 |
| 5 | 15.0 | 0.00 | 1.50 | 0.00 | 13.50 |
| Total | 130.0 | 35.23 | 9.48 | 85.29 |
The pref grows to 33.60 in year 1, takes the whole 20.0 distribution and is cleared in year 2. From then on it takes 10 per cent of everything. It receives 44.71 for 30.0: a 1.49x multiple and an IRR of 25.5 per cent. The kicker, 9.48, is more than the priority return itself.
The seller receives 30.0 now and 85.29 later. Discounted at its 10 per cent rate, the retained cash is worth 61.47, so the deal is worth 91.47, or 91.5 per cent of NAV. That beats the 85 sale by 6.47. Keeping the whole portfolio would have been worth 99.08 at the same rate, so the pref costs the seller 7.60 in value for 30.0 of liquidity.
Put another way, the pref beats the sale for any seller discount rate below 13.7 per cent. A seller that believes the base case and values deferred cash at 10 per cent should prefer the pref; a seller that needs the cash and would otherwise borrow expensively may not.
In the stress case distributions fall to 90.0 and arrive later. The pref balance compounds to 25.60 after year 1 and is not cleared until year 3. The investor still receives 43.37, a 1.45x multiple and 17.2 per cent. The seller receives nothing for two years and 46.63 in total, worth 31.44 today: a deal value of 61.44, 23.56 below the 85 sale. A buyer at 85 would have earned 1.7 per cent on the same stress; the pref investor earned 17.2.
| Pref advanced | Pref IRR, base | Seller value, base | Pref IRR, stress | Seller value, stress |
|---|---|---|---|---|
| 20 | 37.0% | 90.80 | 23.4% | 60.94 |
| 30 | 25.5% | 91.47 | 17.2% | 61.44 |
| 40 | 20.3% | 92.14 | 14.5% | 61.89 |
| 50 | 17.0% | 92.67 | 13.0% | 62.22 |
A small pref with a fixed kicker is expensive: at 20 the investor earns 37.0 per cent in the base case, because 10 per cent of the tail is a large reward for a small advance. Negotiate the kicker in proportion to the amount, or cap it at a total multiple.
The deal is a transfer of risk, not a cheaper price. The sale moves the downside to the buyer for a 15 point discount. The pref keeps the downside with the seller and charges for the upside through the kicker. Which one is cheaper depends on which case the seller believes. How much of a buyer's return comes from the discount itself is worked in how much of a secondary return comes from the discount.
The common mistake is comparing the pref's headline rate, 12 per cent, with the implied return to a secondary buyer, and concluding that the pref is the cheaper money. The relevant cost includes the kicker, which here lifts the investor's IRR to 25.5 per cent, and the seller's retained exposure to a weak outcome. Run both structures on the same distribution cases and compare the seller's value in each, not the rates.
The second mistake is ignoring the cushion. At 30 against 100 the loan to value is 30 per cent: NAV can fall 70 per cent before pref capital is impaired. That protection is what the investor is paid for, and it is why the pref still earns 17.2 per cent when the sale buyer would earn 1.7.
A preferred equity secondary is worth more than an outright sale when the portfolio delivers and much less when it does not: 91.47 against 85 in the base case, 61.44 in the stress. Price it as a waterfall on two or more cash flow cases, at the seller's own discount rate. The free workbook for this case projects distributions year by year and stresses delay and value together, which gives exactly the cash flows a pref waterfall needs.
The priority return plus the kicker, and the kicker often dominates. On 30 advanced against 100 of NAV at a 12 per cent priority return with 10 per cent of later distributions, the investor receives 44.71: 1.49x and an IRR of 25.5 per cent in the base case. Even when distributions fall to 90 and arrive later, it earns 17.2 per cent.
Only if the portfolio performs. Against an 85 sale, 30 of pref plus the retained distributions discounted at 10 per cent are worth 91.47 in the base case, 6.47 more. In a stress where distributions total 90, the same deal is worth 61.44, 23.56 less than the sale, because the seller kept every loss.
Measure it as loan to value: the pref amount over the NAV it sits on. At 30 against 100 the LTV is 30 per cent, so NAV can fall 70 per cent before pref capital is impaired, and distributions must also cover the 12 per cent priority return as it compounds.
This article is one calculation from The Private Equity Secondaries Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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