Per-deal blockers tax every winner in full and give nothing back on the losers, which is why the co-investor's cost is higher than the fund's.
A blocker corporation costs a co-investor its combined corporate tax rate on the gain, plus a small running cost, and nothing on the capital returned. On an illustrative $20.0m co-investment exited at 2.50x after five years, a 25 per cent blocker tax takes $7.5m and running costs $0.2m: the net multiple falls to 2.115x and the IRR from 20.11 to 16.16 per cent, a drop of 395 basis points. Two structural facts move that number more than any negotiation on fees: whether the exit is a sale of the blocker's shares rather than of its assets, and whether each deal sits in its own blocker.
Worked in full in The Co-Investment Practitioner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Tax-exempt and non-US investors usually cannot hold a US pass-through company directly without receiving unrelated business taxable income or income effectively connected with a US business. The standard answer is a blocker: a US corporation that holds the co-investment, pays corporate tax and distributes what is left. Funds build blockers into their structure as a matter of course. A co-investor, writing a single cheque into a single deal, often has to set one up for that deal alone, and the cost behaves differently from the fund-level version.
| Input | Value |
|---|---|
| Co-investment cheque, paid into a new blocker | 20.0 |
| Gross multiple at exit | 2.50x |
| Holding period | 5 years |
| Federal corporate tax rate | 21% |
| State tax, net of the federal deduction | 4% |
| Combined blocker tax rate | 25% |
| Blocker running costs (tax returns, administration) | 0.04 a year |
To isolate the exit, the pass-through company is assumed to allocate no net taxable income to the blocker during the hold (interest and depreciation absorb it), the blocker is liquidated after the sale with no further withholding, and the running costs are deducted from the exit proceeds, undiscounted. The first two assumptions need checking with tax counsel on a real deal.
Exit proceeds = 20.0 × 2.50 = $50.0m; gain = 50.0 − 20.0 = $30.0m
Blocker tax = gain × combined rate = 30.0 × 25% = $7.5m
Running costs = 0.04 × 5 = $0.2m
Net to the co-investor = 50.0 − 7.5 − 0.2 = $42.3m, or 42.3 ÷ 20.0 = 2.115x
IRR = 2.115^(1/5) − 1 = 16.16%, against 2.50^(1/5) − 1 = 20.11% before any blocker tax
Excel, tax only: =1+(GrossMOIC-1)*(1-TaxRate) gives 2.125
The blocker takes 0.385 of a turn, which is 25.7 per cent of the profit. It takes none of the capital, so the useful way to think about it is as a haircut on the gain, not on the multiple. That has a consequence the next table makes plain.
| Gross MOIC | Proceeds | Blocker tax | Net MOIC | Turns lost | IRR before tax | IRR via blocker | Drop, bp |
|---|---|---|---|---|---|---|---|
| 1.00x | 20.0 | 0.00 | 0.990x | 0.010 | 0.00% | −0.20% | 20 |
| 1.50x | 30.0 | 2.50 | 1.365x | 0.135 | 8.45% | 6.42% | 203 |
| 2.50x | 50.0 | 7.50 | 2.115x | 0.385 | 20.11% | 16.16% | 395 |
| 3.50x | 70.0 | 12.50 | 2.865x | 0.635 | 28.47% | 23.43% | 504 |
The blocker is cheap on a deal that returns capital and expensive on a winner. A co-investment programme that underwrites to a 2.50x gross target should therefore underwrite to roughly 2.1x net of the blocker, not apply a flat deduction across the book.
If the buyer acquires the blocker's shares rather than the blocker selling its interest in the company, the blocker never realises the gain and the seller, being tax-exempt or non-US, typically pays no US tax on the share sale. The tax does not disappear: the buyer inherits a blocker whose basis in the company is still $20.0m and will pay the tax when it sells. So the buyer prices it in, and the question becomes how much of the $7.5m it deducts.
| Buyer's deduction, % of the $7.5m | Price reduction | Net to co-investor | Net MOIC | IRR |
|---|---|---|---|---|
| 0% | 0.00 | 49.80 | 2.49x | 20.02% |
| 40% | 3.00 | 46.80 | 2.34x | 18.53% |
| 70% | 5.25 | 44.55 | 2.23x | 17.37% |
| 100% | 7.50 | 42.30 | 2.11x | 16.16% |
At a 40 per cent deduction the co-investor keeps $4.5m more than on an asset sale. Whether a buyer will take the blocker at all is outside the co-investor's control: a strategic buyer wanting a step-up in basis will insist on buying the company, and the co-investor's interest usually has to follow the fund's exit route under the drag-along. It is worth asking at the outset whether the shareholders' agreement lets the co-investor's blocker be sold as such.
A fund-level blocker holding several companies nets gains against losses. A co-investor with a separate blocker for each deal cannot. Take two $20.0m co-investments, one exiting at 2.50x and one at 0.50x: $40.0m invested, $60.0m returned, 1.50x gross.
| Structure | Taxable gain | Blocker tax | Net proceeds | Net MOIC |
|---|---|---|---|---|
| One blocker per deal | 30.0 | 7.5 | 52.5 | 1.312x |
| One pooled blocker | 20.0 | 5.0 | 55.0 | 1.375x |
The separate blockers pay $2.5m more, an effective rate of 37.5 per cent on the $20.0m actually earned. The $10.0m loss sits in a blocker with no gains to use it against.
The common mistake is to model the blocker as a fixed annual cost, or as a percentage of the fund-level tax drag quoted by the GP. The fund's figure benefits from pooling; a single-deal blocker does not. The cost is the tax rate times each winning deal's gain, and it lands hardest on exactly the deals that make a co-investment programme work.
Model a blocker as 25 per cent (or whatever the combined rate is) of each deal's gain, with no offset for losers unless the deals share a blocker. On the illustrative winner it turns 2.50x into 2.115x and costs 395 basis points of IRR, more than the transaction and monitoring fees a co-investor usually fights over. Whether deals can share a blocker, and whether a blocker sale stays available as an exit, are the two structural points to raise with tax counsel before the first cheque; this is arithmetic, not tax advice. The companion files include the free workbook for this case and a blank version for your own programme, and the separate article on a blocker's deferred tax liability shows how the same tax is carried in NAV before exit.
Tax-exempt and non-US investors holding a US pass-through company directly would receive business income they want to avoid: unrelated business taxable income for a tax-exempt, effectively connected income for a non-US investor. A US corporation between them and the company pays the tax instead. On an illustrative $30.0m gain at a 25 per cent combined rate, that tax is $7.5m.
Partly. The seller usually pays no US tax on the share sale, but the buyer inherits the blocker's low basis and deducts part of the embedded tax from the price. If the buyer deducts 40 per cent of a $7.5m liability, the co-investor nets $46.8m instead of $42.3m on a $50.0m exit, 2.34x instead of 2.11x.
Barely. There is no gain to tax, so the cost is only the running expense: on a $20.0m cheque returned at 1.00x, the net multiple is 0.990x after $0.2m of costs. The loss is trapped in the blocker, though, and cannot shelter the gain on another deal unless both sit in the same blocker.
This article is one calculation from The Co-Investment Practitioner. 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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