Current pay, compounding accrual and a minimum multiple, on a $10 million preferred equity position, year by year.
A preferred equity return is the IRR of three cash flows: the current-pay coupon each period, the accrual added to the balance, and the redemption of par plus everything accrued. On an illustrative $10,000,000 position with a 10 per cent preferred rate, 7 per cent paid in cash and 3 per cent accruing at the full rate, a four-year hold redeems at $11,392,300 and returns 10.00 per cent a year and 1.42x. Change the compounding or add a minimum multiple and the same headline rate produces a different return.
Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Preferred equity is the layer a sponsor uses to fill the gap between the senior loan and its own equity when it cannot or will not add more debt (how a sponsor sizes that choice against a paydown is worked in closing a refinancing gap). To the investor holding it, the return looks like a loan's: a fixed rate and a redemption date. But it is written in an operating agreement, not a loan agreement, and three terms in that document decide what the headline rate actually yields.
| Term | Value |
|---|---|
| Investment (par) | $10,000,000 |
| Preferred return | 10% a year |
| Current pay, in cash | 7% of par |
| Accrual | the 3% balance, compounding |
| Expected redemption | end of year 4 |
| Minimum multiple on early redemption | 1.30x |
Payments are annual here to keep the table readable; in practice they are usually monthly or quarterly, which changes the figures slightly but not the method.
Return due = preferred rate × opening balance; cash paid = current rate × par; accrual = return due − cash paid; closing balance = opening balance + accrual
In Excel, with the opening balance in B3: =10%*B3 for the return due, =7%*10000000 for the cash and =B3+10%*B3-7%*10000000 for the closing balance.
| Year | Return due | Cash paid | Accrued | Closing balance |
|---|---|---|---|---|
| 1 | 1,000,000 | 700,000 | 300,000 | 10,300,000 |
| 2 | 1,030,000 | 700,000 | 330,000 | 10,630,000 |
| 3 | 1,063,000 | 700,000 | 363,000 | 10,993,000 |
| 4 | 1,099,300 | 700,000 | 399,300 | 11,392,300 |
The cash coupon is flat at $700,000; the accrual grows each year because the full 10 per cent is charged on a balance that includes past accruals.
The investor's cash flows are −$10,000,000 at the start, $700,000 in each of years 1 to 3, and $700,000 plus the $11,392,300 redemption in year 4. Total cash received is $14,192,300.
IRR = 10.00 per cent; equity multiple = 14,192,300 / 10,000,000 = 1.42x
=IRR(B2:B6) on the five cash flows. When the unpaid return compounds at the preferred rate, the IRR equals the preferred rate whatever the split between cash and accrual and whenever the redemption falls.
Only $2,800,000 of the return arrives in cash during the hold; the other $1,392,300 depends on the sponsor refinancing or selling at the end. That is the risk the accrual carries: the higher the accrued share, the more the investor's return rests on an exit that the senior lender is paid from first.
If the agreement accrues 3 per cent of par each year without compounding, the year-4 redemption falls to $11,200,000, $192,300 less, and the IRR to 9.60 per cent. Same headline, 40 basis points lower. The words to look for are "compounded" and "on the unpaid balance".
The minimum multiple works the other way. Without it, the IRR is 10.00 per cent whenever the sponsor redeems, but the profit in dollars shrinks with the hold. With a 1.30x floor, an early redemption must top up the investor to $13,000,000 of total cash.
| Redeemed in year | Redemption | Multiple | IRR | Top-up at 1.30x | Multiple with floor | IRR with floor |
|---|---|---|---|---|---|---|
| 1 | 10,300,000 | 1.10x | 10.00% | 2,000,000 | 1.30x | 30.00% |
| 2 | 10,630,000 | 1.20x | 10.00% | 970,000 | 1.30x | 14.46% |
| 3 | 10,993,000 | 1.31x | 10.00% | 0 | 1.31x | 10.00% |
| 4 | 11,392,300 | 1.42x | 10.00% | 0 | 1.42x | 10.00% |
| 5 | 11,831,530 | 1.53x | 10.00% | 0 | 1.53x | 10.00% |
The floor stops binding in year 3, when the natural multiple reaches 1.31x. For the sponsor, this is the price of flexibility: a business plan that might refinance in year 2 has to carry a $970,000 cost that the headline 10 per cent does not show. For how preferred equity compares with mezzanine on the sponsor's side, see mezzanine vs preferred equity.
Roll the balance forward at the preferred rate, pay the coupon, redeem par plus accrual and take the IRR: 10.00 per cent and 1.42x on these terms. Then read the compounding and minimum multiple clauses, because they move the result more than the headline does. Private Equity Real Estate sets preferred equity inside the capital stack it builds layer by layer, and the free workbooks for this case include the stack with what each layer recovers across a range of exit values; the cost of the whole stack is worked in the blended cost of a capital stack.
Illustratively, preferred equity is priced between mezzanine debt and common equity, and the stated rate is usually split between a current-pay coupon and an accrual. The split matters as much as the total: in the example a 10 per cent pref paying 7 per cent in cash returns 10.00 per cent only because the accrued 3 per cent compounds at the full rate; on simple accrual it returns 9.60 per cent.
A floor on the total cash returned, expressed as a multiple of the investment, payable if the sponsor redeems early. It protects the investor from being repaid after a year with little profit. In the example a 1.30x floor costs the sponsor a $970,000 top-up on a year-two redemption, lifting the investor's IRR to 14.46 per cent, and stops binding from year three.
Legally equity: it sits in the ownership vehicle, below all the mortgage and mezzanine debt, with no lien on the property. Economically it behaves like subordinated debt, with a fixed return, a redemption date and remedies such as taking control of the vehicle if the sponsor defaults. Lenders usually treat it as equity for leverage tests, which is why sponsors use it.
This article is one calculation from Private Equity Real Estate. 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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