When does a preferred return make sense for cash providers?

[Clark Kirkpatrick]

I know what a preferred return is, and I've heard people say that there are deals when it makes sense, and deals when it doesn't. Obviously I'm only looking at equity deals here.

Thanks!!

[Spencer Gray]

The preferred return in many ways is a measure of perceived risk and the premium paid by the sponsor to the investor for that risk. The higher the preferred return the higher level of perceived risk. That risk is mostly related to the experience of the sponsor just as @Andrew Hogan explained. 

A preferred return doesn't make as much sense in deals where there is no or very little cash flow in the the deal such as a new development or a very heavy rehab/reposition. There still may be a preferred return as LPs want some idea of a minimum return on their equity even if it is accruing not not actually being distributed. In these deals instead of a preferred return there may be a series of waterfall hurdles bases on the IRR of the project. This is often more useful from a sponsors perspective since there is no pref being accrued and the splits are based on the eventual disposition or other capital event.