Pro rata, a sponsor loan or a completion guarantee: the same overrun run through the same waterfall gives three very different answers.
It depends on how the agreement makes the sponsor fund it, and the three usual routes split the same overrun very differently. On an illustrative 90/10 development JV with a $4.0m overrun, funding it pro rata as ordinary capital costs the sponsor $1.26m of profit, more than three times its $0.4m share, because the overrun comes out of the promote; a sponsor overrun loan at 12 per cent costs it $0.86m; a completion guarantee funded as uncredited capital costs it the full $4.0m and leaves the investor's 14.1 per cent IRR untouched.
Worked in full in Real Estate Joint Ventures by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Cost overruns are the most common dispute in development joint ventures, and the term sheet usually settles them in a sentence: overruns above a contingency are funded by the sponsor, or by the members pro rata, or by member loans. Each sentence produces a different waterfall. The arithmetic below runs one venture through all three.
| Input | Value |
|---|---|
| Equity budget at closing (investor 90%, sponsor 10%) | 40.0 (36.0 / 4.0) |
| Cost overrun, funded at the end of year 2 | 4.0 |
| Net sale proceeds to equity at the end of year 3 | 62.0 |
| Tier 1: return of capital plus 8% compounded preferred return, pro rata | 8% |
| Tier 2: remaining cash, investor / sponsor | 70 / 30 |
| Interest on a sponsor overrun loan, compounded, paid ahead of the waterfall | 12% |
Without the overrun, the same $62.0m on $40.0m would give the investor $53.48m, a 14.1 per cent IRR, and the sponsor $8.52m, of which $2.32m is promote.
Investor funds 3.6 and sponsor 0.4 at year 2. Each contribution earns the 8 per cent pref from the date it is made.
Tier 1 = 36.0 × 1.083 + 3.6 × 1.08 + (4.0 × 1.083 + 0.4 × 1.08) = 49.24 + 5.47 = 54.71
Tier 2 = 62.0 − 54.71 = 7.29, split 70/30.
Investor: 49.24 + 0.70 × 7.29 = 54.34 on 39.6 paid in, a profit of 14.74 and an IRR of 11.8%.
Sponsor: 5.47 + 0.30 × 7.29 = 7.66 on 4.4, a profit of 3.26; its promote falls from 2.32 to 1.46.
The overrun adds capital that earns a pref but no extra value, so it pushes more of the proceeds into Tier 1 and shrinks Tier 2, which is where the sponsor's promote lives. The sponsor loses $1.26m of profit and the investor $2.74m.
Sponsor lends 4.0 at year 2; repayment at exit = 4.0 × 1.12 = 4.48, paid before the waterfall.
To the waterfall: 62.0 − 4.48 = 57.52. Tier 1 = 45.35 + 5.04 = 50.39; Tier 2 = 7.13.
Investor: 45.35 + 0.70 × 7.13 = 50.34 on 36.0, a profit of 14.34, IRR 11.8%.
Sponsor: 5.04 + 0.30 × 7.13 + 4.48 = 11.66 on 8.0, a profit of 3.66.
The investor's IRR is the same as under Route A, 11.83 against 11.81 per cent, but it now has $0.40m less profit, and the sponsor has $0.40m more. Most of that shift comes from the loan sitting ahead of the waterfall, not from the coupon: at 8 per cent, the same rate as the pref, the loan still costs the sponsor only $0.98m against $1.26m pro rata.
Sponsor pays 4.0 into the project with no capital account credit, no pref and no repayment.
Waterfall unchanged: investor 53.48 (IRR 14.1%), sponsor 8.52 on 8.0 paid in, a profit of 0.52.
| Route | Investor IRR | Investor profit | Sponsor profit | Cost to investor | Cost to sponsor |
|---|---|---|---|---|---|
| No overrun | 14.1% | 17.48 | 4.52 | 0.00 | 0.00 |
| A: pro rata capital | 11.8% | 14.74 | 3.26 | 2.74 | 1.26 |
| B: sponsor loan at 12% | 11.8% | 14.34 | 3.66 | 3.14 | 0.86 |
| C: completion guarantee | 14.1% | 17.48 | 0.52 | 0.00 | 4.00 |
Each row costs exactly $4.00m between the two partners; only the split moves. That makes the clause a pure negotiation over who wears the risk, which is why it should be priced, not drafted as boilerplate.
| Overrun | A: investor IRR | A: sponsor profit | B: investor IRR | B: sponsor profit | C: sponsor profit |
|---|---|---|---|---|---|
| 2.0 | 13.0% | 3.89 | 13.0% | 4.09 | 2.52 |
| 4.0 | 11.8% | 3.26 | 11.8% | 3.66 | 0.52 |
| 8.0 | 9.5% | 1.99 | 9.5% | 2.79 | −3.48 |
Under a completion guarantee the investor stays at 14.1 per cent whatever happens, and an $8.0m overrun turns the sponsor's $4.0m stake into a $3.48m loss. That is the point of the guarantee, and also its limit: a sponsor facing that loss has every incentive to stop funding, so the guarantee is only as good as the sponsor's balance sheet. When the sponsor cannot fund at all, the question becomes rescue capital, covered in how rescue capital changes the promote.
Treating pro rata funding as fair because each partner pays its percentage. The sponsor pays 10 per cent of the cash, $0.4m, but bears 31.6 per cent of the cost, $1.26m, because the overrun is taken from the residual tier where it holds 30 per cent. Investors who think pro rata protects them are partly right; sponsors who think it costs them 10 per cent are wrong by a factor of three. Run the clause through the waterfall before agreeing which route applies; the multi-tier waterfall works the same tiers with interim cash flows.
Drafting point: a priority overrun loan moves part of the overrun from the sponsor to the investor: $0.40m against pro rata funding at a 12 per cent rate, and still $0.29m with the rate capped at the 8 per cent pref. A rate cap narrows the shift but does not remove it, so price the loan route against pro rata funding before accepting it.
The same $4.0m overrun costs the sponsor $1.26m funded pro rata, $0.86m as a 12 per cent loan and $4.0m under a completion guarantee. Price the clause in the term sheet, at the overrun you think plausible. The book's remedies workbook, beside the live waterfall and promote engine, is in the free workbook for this case, and a blank structure is in the JV waterfall and promote model.
Pro rata looks neutral but is not. In the illustrative venture the sponsor funds $0.4m of a $4.0m overrun yet loses $1.26m of profit, because extra capital earns the pref and pushes proceeds out of the tier where the sponsor takes 30 per cent. The investor loses $2.74m and its IRR falls from 14.1 to 11.8 per cent.
An undertaking by the sponsor to fund overruns itself, usually without capital account credit. It protects the investor fully: the investor stays at a 14.1 per cent IRR in the illustrative case, while the sponsor's profit falls from $4.52m to $0.52m on a $4.0m overrun and becomes a $3.48m loss on an $8.0m one.
Less than it looks. A 12 per cent loan repaid ahead of the waterfall leaves the investor's IRR at 11.8 per cent, the same as pro rata funding, but with $0.40m less profit, which the sponsor gains. Capping the rate at the 8 per cent pref only narrows the gap: the sponsor's cost is then $0.98m against $1.26m pro rata, because the priority repayment, not the coupon, does most of the work.
This article is one calculation from Real Estate Joint Ventures. 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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