“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.
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