“Cumulative” means carried over from year to year. “Compounding” means the unpaid balance is added to the principal and it, too, accrues the return.
For instance, with a cumulative preferred return, if someone invested $100,000 and you owed them an 8% cumulative preferred return that didn’t get paid in Year 1, you would owe them $8,000 that would carry forward. In Year 2, you would owe them $8,000 for Year 1 plus another $8,000 for Year 2, for a total due of $116,000 in the event of a capital transaction.
If your waterfall had an 8% compounding preferred return, you would add the unpaid preferred return from Year 1 to their $100,000 capital contribution, so in Year 2, you would owe them an 8% preferred return on $108,000, or $8640; so the total owed to that investor in the event of a capital transaction would be $116,640.
Most preferred returns are cumulative, but non-compounding.
You could have a non-cumulative preferred return. If your non-cumulative preferred return was 8%, you would give 100% of the Distributable Cash to your Investor class first, but if it didn’t equal 8% in any given year, you would start over in the next year, with no arrearages or deficiencies to be paid back later.
We get potential clients who reach out to us every week who want to start a fund. While we could simply take their money and set them up with fund offering documents, we actually talk a lot of people out of doing a fund. Why? Because they don’t have the necessary...