Simple vs Compound Preferred Return: How the Math Works

Most LPAs specify a preferred return, typically 8%. But the way that 8% accrues depends on whether it's simple or compound, and the difference changes LP payouts. Here's how the math works, with real numbers.

Simple Preferred Return

Simple pref accrues on the original contributed capital only. If an LP contributes $1,000,000 with an 8% annual pref, the accrual is $80,000 per year regardless of whether prior pref was paid. After 3 years with no distributions: total pref accrued = $240,000. The base never changes.

Compound Preferred Return

Compound pref accrues on contributed capital plus any unpaid prior pref. Same $1,000,000 contribution, same 8%:

Why It Matters for the Waterfall

The preferred return threshold determines when distributions move to the next tier. If you're calculating simple when the LPA says compound (or vice versa), the pref hurdle is either overstated or understated. This shifts when the GP earns promote and changes every allocation downstream.

How to Check Your Model

Look at the pref accrual formula in your spreadsheet. Does it reference only the original contribution amount, or does it reference a rolling balance that includes prior unpaid pref? If it's a flat percentage calculation applied to the same base every period, it's simple. If the base grows each period by the unpaid amount, it's compound. Compare this to what your LPA specifies.

The preferred return is the foundation of your waterfall. If the pref accrual method doesn't match the LPA, every tier above it calculates on the wrong base.