A promote is a convex claim on the venture's upside, so the base case and a liquidation at today's value both understate what it is worth.
Value a promote by running the waterfall on a range of exit outcomes, weighting each promote by its probability, and discounting the expected figure at a rate fit for a geared, junior claim. On an illustrative 100.0 joint venture with an expected exit equity of 180.00, the promote at the expected exit is 3.41, but the expected promote is 5.08, 49 per cent more, and worth 2.52 today at a 15.0 per cent discount rate. A hypothetical liquidation at today's value says it is worth nothing.
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 →
A promote pays nothing below the hurdle and an increasing share of each extra unit of profit above it. A payoff shaped like that is convex: the gain in good outcomes is larger than the loss in bad ones, because the loss is floored at zero. The promote calculated at the average exit is therefore never higher than, and usually well below, the average of the promotes across exits. Sponsors who value their promote for a GP stake sale, a compensation plan or a lender's review, and investors who price a buyout of it, both need the second figure.
| Input | Value |
|---|---|
| Equity: investor / sponsor | 90.0 / 10.0 |
| Tier 1: pro rata until the investor earns | 10.0% IRR |
| Tier 2: promote to the sponsor until the investor earns 15.0% IRR | 20.0% |
| Tier 3: promote above that | 30.0% |
| Discount rate for the promote | 15.0% |
| Scenario | Probability | Exit equity |
|---|---|---|
| Severe downside | 10% | 110.0 |
| Downside | 20% | 150.0 |
| Base | 40% | 180.0 |
| Upside | 20% | 210.0 |
| Strong upside | 10% | 250.0 |
| Expected | 100% | 180.00 |
Investor cash at hurdle 1 = 90.0 × 1.105 = 144.95, reached at total exit equity of 144.95 ÷ 90% = 161.05
Investor cash at hurdle 2 = 90.0 × 1.155 = 181.02
In tier 2 the investor takes 90% × (1 − 20%) = 72.0% of each unit, so hurdle 2 is reached at 161.05 + (181.02 − 144.95) ÷ 72.0% = 211.16
Above 211.16 the investor takes 90% × (1 − 30%) = 63.0%
Promote = sponsor's cash − 10% of total exit equity
| Exit equity | Investor | Investor IRR | Sponsor | Promote | Probability × promote |
|---|---|---|---|---|---|
| 110.0 | 99.00 | 1.92% | 11.00 | 0.00 | 0.00 |
| 150.0 | 135.00 | 8.45% | 15.00 | 0.00 | 0.00 |
| 180.0 | 158.59 | 12.00% | 21.41 | 3.41 | 1.36 |
| 210.0 | 180.19 | 14.89% | 29.81 | 8.81 | 1.76 |
| 250.0 | 205.49 | 17.95% | 44.51 | 19.51 | 1.95 |
| Expected 180.00 | 5.08 |
Two outcomes out of five pay nothing, yet the expected promote, 5.08, is 1.67 above the 3.41 the base case pays. The difference is the convexity: the two upside cases add more promote than the two downside cases take away.
Present value = 5.08 ÷ 1.155 = 2.52
Excel, with probabilities in B2:B6 and promotes in C2:C6: =SUMPRODUCT(B2:B6,C2:C6)/1.15^5
The rate should be above the venture's equity rate. The promote is a geared slice of the equity's upside, and its value moves several times as much as the equity's for the same change in the exit. At 10.0 per cent, taken here as the venture's equity rate, the present value is 3.15; at 20.0 per cent, 2.04. For scale, 2.52 is 25.2 per cent of the sponsor's 10.0 co-investment, a material part of what the sponsor's interest is worth.
| Spread | Range of exits | Expected promote | Present value at 15% |
|---|---|---|---|
| None (base case only) | 180.0 | 3.41 | 1.70 |
| Half | 145.0 to 215.0 | 3.73 | 1.86 |
| As assumed | 110.0 to 250.0 | 5.08 | 2.52 |
| One and a half times | 75.0 to 285.0 | 6.81 | 3.39 |
More uncertainty, with the same average, makes the promote more valuable: it is an option, and options gain from volatility. The investor's position moves the other way. Shift every scenario down by 20.0, so the expected exit is 160.0, just below the 161.05 at which the first hurdle clears. The promote at the expected exit is then zero, but the expected promote is still 2.45. A base-case-only valuation would tell a buyer of the promote it is getting something for nothing; the expected figure tells it what the seller is giving up. Shift the scenarios up by 20.0 and the expected promote is 8.44, against 7.01 at the expected exit.
Using a hypothetical liquidation at today's value. That is the right tool for a buy-sell or a removal, where the agreement says to value the interests as if the asset were sold now, as in how a JV buy-sell price is calculated. As a valuation it fails: liquidate this venture at its 100.0 cost today and the promote is 0.00, although the sponsor holds a claim worth 2.52. The second mistake is discounting the expected promote at the equity rate, 10.0 per cent here, which overstates it by 0.63. The third is choosing scenario probabilities that average to a business plan exit nobody actually expects; the scenarios should average to the honest central view, not the target.
Illustrative. A full valuation would use the venture's own waterfall, interim distributions, the timing distribution of the exit and any clawback or lookback, which moves value back to the investor in exactly the upside cases that drive the expected promote.
A promote is worth the probability-weighted waterfall, discounted at a rate above the equity's: 5.08 expected and 2.52 today in this venture, against 3.41 at the base case and nothing on a liquidation at cost. Build the scenarios before the promote is sold, pledged or bought out. The book works the waterfall and its convexity in full, and the free workbook for this case resolves the tiers at any exit value. To see where the first hurdle bites, read at what exit price a JV promote starts to pay.
Because the promote pays nothing below the hurdle and a rising share above it, so the extra promote in upside cases outweighs the promote lost in downside cases, which cannot fall below zero. In the worked venture the promote at the 180.00 expected exit is 3.41, while the average across five weighted scenarios is 5.08, 49 per cent more.
A rate above the venture's equity rate, because the promote is a geared slice of the equity's upside. In the worked case an expected promote of 5.08 in year five is worth 3.15 at 10.0 per cent, 2.52 at 15.0 per cent and 2.04 at 20.0 per cent. Using the equity rate overstates it by 0.63.
Yes. If the expected exit equity in the worked case falls to 160.0, just below the 161.05 at which the first hurdle clears, the promote at the expected exit is zero, but the probability-weighted promote is still 2.45, because the upside scenarios clear the hurdle.
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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