Promote drag across deal outcomes and hold periods on an illustrative two-tier joint venture waterfall, and why the rule of thumb understates it.
Run the waterfall on the deal's cash flows and compare the investor's IRR with the deal IRR before promote: the gap is the promote drag. On an illustrative $50,000,000 joint venture with an 8 per cent preferred return, a 20 per cent promote to 12 per cent and 30 per cent above it, a deal returning 15 per cent gives the investor 13.53 per cent, a drag of 147 basis points. The rule of thumb, 20 per cent of the return above the hurdle, says 140 and falls further behind as the deal improves.
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 →
An investor puts up 90 per cent and a sponsor 10 per cent of $50,000,000 of equity. The property pays a 5 per cent cash yield on equity each year and is sold at the end of year five. The exit price is set so that the deal, before any promote, returns exactly the gross IRR being tested. All terms are illustrative.
| Tier | Hurdle (investor IRR) | Investor | Sponsor |
|---|---|---|---|
| 1. Return of capital and preferred return | up to 8% | 90% | 10% |
| 2. First promote, 80/20 | 8% to 12% | 72% | 28% |
| 3. Second promote, 70/30 | above 12% | 63% | 37% |
The sponsor's column in tiers 2 and 3 is its promote plus its 10 per cent share of what is left: 20 per cent plus 10 per cent of the remaining 80 is 28, and 30 per cent plus 10 per cent of the remaining 70 is 37.
1. Deal cash flows. At a 15 per cent gross IRR, equity of $50,000,000 receives $2,500,000 a year for four years and $86,211,906 in year five. Deal profit is $46,211,906, a 1.92x multiple.
2. Hurdle accounts. Keep one balance per hurdle for the investor: its contributions, compounded at 8 per cent in one account and at 12 per cent in the other, less everything it receives. Each year's cash goes 90/10 until the 8 per cent balance is zero, then 72/28 until the 12 per cent balance is zero, then 63/37. The interim distributions of $2,500,000 never clear the 8 per cent hurdle, so all promote is paid out of the exit.
3. Promote and investor IRR. The promote is $5,794,218, 12.5 per cent of deal profit. The investor receives $81,375,919 on $45,000,000, instead of $86,590,716 with no promote: $5,214,797 less, its 90 per cent share of the promote.
Investor IRR = IRR(−45,000,000; its receipts each year) = 13.53%
Promote drag = gross IRR − investor IRR = 15.00% − 13.53% = 147 bp
Excel: =IRR(DealCF)-IRR(InvestorCF), with the tiers solved by hurdle account, not by a fixed percentage of profit
The investor gives up 12.5 per cent of its profit but only about a tenth of its IRR, and its multiple falls from 1.92x to 1.81x. The sponsor, on its 10 per cent, earns 25.66 per cent. Investment committees often see the deal IRR in the paper and the net IRR only at the end of the hold; both belong on the same page.
| Gross deal IRR | Investor IRR | Drag | Rule of thumb | Promote |
|---|---|---|---|---|
| 8% | 8.00% | 0 bp | 0 bp | 0 |
| 10% | 9.61% | 39 bp | 40 bp | 1,292,570 |
| 12% | 11.25% | 75 bp | 80 bp | 2,687,013 |
| 14% | 12.79% | 121 bp | 120 bp | 4,604,287 |
| 15% | 13.53% | 147 bp | 140 bp | 5,794,218 |
| 16% | 14.27% | 173 bp | 160 bp | 7,027,920 |
| 18% | 15.77% | 223 bp | 200 bp | 9,631,356 |
| 20% | 17.30% | 270 bp | 240 bp | 12,424,247 |
| 25% | 21.21% | 379 bp | 340 bp | 20,301,740 |
Below the 8 per cent hurdle the drag is zero. Between 8 and about 13 per cent gross the rule of thumb is close, if anything slightly high, because only the first promote is active. Once the investor's net return passes 12 per cent, which here happens at a gross IRR of about 13 per cent, the 30 per cent tier switches on and the drag runs ahead: at 25 per cent gross it is 379 basis points against the 340 the shortcut implies. The drag is convex in performance, which is the point of a tiered promote and the reason a sponsor's best deals cost the investor most.
| Hold | Investor IRR | Drag | Promote | Gross / investor multiple |
|---|---|---|---|---|
| 3 years | 13.46% | 154 bp | 2,880,270 | 1.50x / 1.44x |
| 5 years | 13.53% | 147 bp | 5,794,218 | 1.92x / 1.81x |
| 8 years | 13.62% | 138 bp | 12,416,998 | 2.77x / 2.52x |
| 10 years | 13.67% | 133 bp | 18,975,283 | 3.53x / 3.15x |
In IRR terms the drag barely moves with the hold. In dollars it more than sextuples from three to ten years, because a 15 per cent IRR compounded for longer produces far more profit above the hurdles. An investor that measures the promote in basis points and a sponsor that measures it in dollars can both be right.
Quoting the promote drag as "20 per cent of the excess over the pref" is a fair approximation for a single-tier waterfall paid once at exit, and nothing else. With a second tier it understates; with large interim distributions that clear the hurdle early, or a catch-up, it misstates again. The only reliable figure comes from running the investor's own cash flows through the hurdle accounts. For how the tiers themselves are solved, see how to calculate a multi-tier IRR waterfall; for the effect of fees on top of the promote, see what a JV sponsor earns from fees vs the promote.
The free workbook for this case computes the investor's return with the promote and without it, which is the comparison a committee needs.
It is the difference between the deal's IRR before promote and the investor's IRR after it. On the illustrative venture a 15 per cent deal gives the investor 13.53 per cent, a drag of 147 basis points, while the promote of $5,794,218 is 12.5 per cent of the deal's profit.
Roughly, and only for a single-tier waterfall paid at exit. With a 30 per cent tier above a 12 per cent investor IRR, a 20 per cent gross deal has a drag of 270 basis points against the 240 the rule implies, and a 25 per cent deal 379 against 340.
Not much in IRR terms, a great deal in dollars. At a constant 15 per cent gross IRR the drag is 154 basis points over three years and 133 over ten, while the promote rises from $2,880,270 to $18,975,283 because far more profit is earned above the hurdles.
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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