One hurdle rises every year the asset is held and the other stands still, so the choice between them is really a bet on the holding period.
It depends on when the asset is sold. A 10 per cent IRR hurdle rises every year the venture is held; a 1.5x equity multiple hurdle stands still, so the two cross at 4.25 years. On an illustrative venture earning 13.0 per cent a year and sold in year six, the multiple hurdle pays the sponsor 11.64 of promote against 6.21 under the IRR hurdle, 87 per cent more on the same building, and cuts the investor's net IRR from 12.43 to 11.92 per cent.
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 joint venture term sheet sets the point above which the sponsor shares in profit. Some measure it as an IRR to the investor, some as an equity multiple, and many as both. In negotiation the two are often treated as interchangeable: 10 per cent a year and one and a half times the money feel like the same ambition for a five-year business plan. They are the same only at one holding period. Before it, the multiple is the harder test. After it, the IRR is, and the gap widens every year the asset is held.
| Input | Value |
|---|---|
| Total equity, investor 90 and sponsor 10 | 100 |
| IRR hurdle | 10.0% |
| Equity multiple hurdle | 1.50x |
| Promote above the hurdle | 20% |
| Gross annual return on the equity | 13.0% |
| Base case exit | Year 6 |
With a single exit, the IRR hurdle is a balance: equity compounded at 10.0 per cent to the exit year. The multiple hurdle is a fixed amount: 1.50 times equity, whenever the exit happens. The promote is 20 per cent of proceeds above whichever threshold applies; the rest is shared 90/10.
Exit proceeds, year six: 100 × 1.136 = 208.20, a gross multiple of 2.08x
IRR hurdle threshold: 100 × 1.106 = 100 × 1.7716 = 177.16. Excess 31.04, promote 20% × 31.04 = 6.21
Multiple hurdle threshold: 100 × 1.50 = 150.00. Excess 58.20, promote 20% × 58.20 = 11.64
Crossover holding period: 1.10T = 1.50, so T = ln 1.50 / ln 1.10 = 4.25 years
In Excel: =LN(1.5)/LN(1.1) for the crossover, and =0.2*MAX(proceeds-MAX(equity*1.1^years,equity*1.5),0) for a hurdle that requires both.
| Hurdle | Threshold | Excess | Promote | Investor receives | Investor net IRR |
|---|---|---|---|---|---|
| 10.0% IRR | 177.16 | 31.04 | 6.21 | 181.79 | 12.43% |
| 1.50x multiple | 150.00 | 58.20 | 11.64 | 176.90 | 11.92% |
| Both required | 177.16 | 31.04 | 6.21 | 181.79 | 12.43% |
The building, the business plan and the exit price are identical. Choosing the multiple hurdle moves 5.43 from investor to sponsor and takes 0.51 points off the investor's net IRR. In year six the IRR test binds; requiring both gives the same answer as the IRR alone.
| Exit year | Proceeds | IRR threshold | Promote, IRR hurdle | Promote, multiple hurdle | Promote, both |
|---|---|---|---|---|---|
| 2 | 127.69 | 121.00 | 1.34 | 0.00 | 0.00 |
| 3 | 144.29 | 133.10 | 2.24 | 0.00 | 0.00 |
| 4 | 163.05 | 146.41 | 3.33 | 2.61 | 2.61 |
| 5 | 184.24 | 161.05 | 4.64 | 6.85 | 4.64 |
| 6 | 208.20 | 177.16 | 6.21 | 11.64 | 6.21 |
| 8 | 265.84 | 214.36 | 10.30 | 23.17 | 10.30 |
| 10 | 339.46 | 259.37 | 16.02 | 37.89 | 16.02 |
Under the IRR hurdle the investor's net IRR barely moves with the exit year, from 12.41 to 12.46 per cent, because the threshold grows with time. Under the multiple hurdle it falls from 13.00 per cent on a quick sale, where no promote is paid, to 11.67 per cent on a ten-year hold. The sponsor is paid for duration, not for performance.
The incentive runs the wrong way. Under a 1.50x multiple hurdle, the gross return needed to earn any promote is 14.47 per cent a year on a three-year hold but only 6.99 per cent over six years and 4.14 per cent over ten. A sponsor with a mediocre asset is rewarded for keeping it. Under the IRR hurdle the bar is 10.00 per cent whatever the hold.
Before agreeing a hurdle, compute the crossover period and compare it with the realistic range of holds, not the business plan's. An investor who expects the hold to run long should insist on an IRR test, or on both. A sponsor confident of a quick exit should prefer the IRR test too, since the multiple can deny a promote on a fast, strong result. The promote-by-exit-year comparison, including a multiple-based waterfall, is built in the free workbook for this case.
Only at the holding period where 1.10 to the power of the years equals 1.50, which is 4.25 years with a single exit. Before that the multiple is harder to clear; after it the IRR is, and on a ten-year hold the multiple needs only 4.14 per cent a year.
Investors usually want both, because each covers the other's weakness. In the illustrative case requiring both gives the IRR result from year five onwards, 6.21 of promote at year six, and the multiple result earlier, which pays nothing on a three-year exit at 13.0 per cent.
Because the threshold is fixed in money while the asset keeps compounding. At a constant 13.0 per cent gross return, the promote under a 1.50x hurdle grows from 2.61 at year four to 37.89 at year ten, while the investor's net IRR falls from 12.55 to 11.67 per cent.
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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