When a new investor buys out the original capital partner, the sponsor's promote is settled at an agreed value and the hurdle resets. Whether the sponsor takes cash or rolls it changes who carries the risk.
The promote is crystallised by running the existing waterfall as if the property were sold at the agreed recapitalisation value, then settling each partner's share. On an illustrative 90/10 joint venture with $40.0m of equity, an 8 per cent pref and a 20 per cent promote, recapitalised after three years at $120.0m, the sponsor's promote crystallises at $2.68m and its whole position at $8.79m. What happens next, cash or roll, and how the new hurdle is set, decides whether the recap helps the sponsor.
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 →
Recapitalisations are common once a value-add business plan is complete. The original capital partner wants its money back at a stabilised value; a new, lower-return investor wants to own a stabilised asset with an operating sponsor in place. Rather than sell the building, the new investor buys the old one's interest, and the sponsor stays. Its promote, until then a contingent claim, has to be turned into a number.
| Input | Value |
|---|---|
| Equity at the start: investor 36.0, sponsor 4.0 | 40.0 |
| Purchase price and senior debt | 95.0 and 55.0 |
| Preferred return, compounding annually, pari passu | 8.0% |
| Promote above the pref, then 90/10 on the rest | 20% |
| Agreed recapitalisation value at year 3 | 120.0 |
| Notional sale costs deducted at the recap and at the exit | 1.0% |
| Sale value at year 7 | 140.0 |
Net equity = 120.0 − 1.2 notional costs − 55.0 debt = 63.8
Pref and capital = 40.0 × 1.083 = 50.39 (investor 45.35, sponsor 5.04)
Residual = 63.8 − 50.39 = 13.41; promote = 20% × 13.41 = 2.68
Remaining 10.73 split 90/10: investor 9.66, sponsor 1.07
Investor = 45.35 + 9.66 = 55.01; sponsor = 5.04 + 1.07 + 2.68 = 8.79
The new investor pays the original investor 55.01, a 1.53x multiple and a 15.18 per cent IRR on its 36.0 over three years. The sponsor's 8.79 is 13.8 per cent of the equity, against the 10 per cent it contributed; the difference is entirely the crystallised promote, since everything else is split in proportion to capital.
The sponsor can take the 2.68 promote in cash, funded by the new investor, and roll only its pro rata 6.11 into the new JV. Or it can roll the whole 8.79 as capital. In both cases the new JV starts with 63.8 of equity and a fresh waterfall on the same terms: 8 per cent pref on the new capital accounts, then a 20 per cent promote, with the rest split in proportion to capital.
| Route | Sponsor capital in new JV | Cash at year 3 | Received at year 7 | Sponsor total | Sponsor IRR |
|---|---|---|---|---|---|
| No recap: original JV runs to year 7 | 0.00 | 11.07 | 11.07 | 15.65% | |
| Recap, promote in cash | 6.11 | 2.68 | 8.01 | 10.69 | 18.79% |
| Recap, everything rolled | 8.79 | 0.00 | 11.52 | 11.52 | 16.32% |
No new promote is paid in either recap route at a $140.0m exit. The new hurdle runs on 63.8 from year 3: 63.8 × 1.084 = 86.80 at year 7, which needs an exit of about $143.2m. Net equity actually grows 7.0 per cent a year after the recap, below the 8.0 per cent pref. The sponsor still does better rolling than not recapping at all, because its 13.8 per cent share participates pro rata in the growth, and the original JV's hurdle, compounding on 40.0 since day one to 68.55, would have taken a larger bite.
| Sale value, year 7 | Net equity | No recap | Recap, promote in cash | Recap, all rolled |
|---|---|---|---|---|
| 120.0 | 63.8 | 6.38 | 8.79 | 8.79 |
| 130.0 | 73.7 | 8.30 | 9.74 | 10.16 |
| 140.0 | 83.6 | 11.07 | 10.69 | 11.52 |
| 150.0 | 93.5 | 13.84 | 12.85 | 14.04 |
| 160.0 | 103.4 | 16.61 | 15.59 | 17.11 |
The recap is insurance for the sponsor. If values stall at $120.0m, the crystallised 8.79 is kept in either route, while without a recap the sponsor would be back below the pref with 6.38. At high exits, rolling everything wins; taking cash gives up some of the upside in exchange for an earlier and certain 2.68, which is why its IRR is highest at the base case even though its dollars are lowest.
| Agreed value | Net equity | Promote | Sponsor position |
|---|---|---|---|
| 105.0 | 48.95 | 0.00 | 4.90 |
| 110.0 | 53.90 | 0.70 | 6.02 |
| 120.0 | 63.80 | 2.68 | 8.79 |
| 130.0 | 73.70 | 4.66 | 11.57 |
Once the value clears the pref, each $10.0m of agreed value moves the promote by 1.98, so the valuation mechanism in the JV agreement, appraisal, third-party offer or negotiated price, is where the sponsor's economics are really decided. The buy-sell price article runs the same deemed-sale logic when one partner forces the other out.
The common mistake is to crystallise on gross value. Without the 1.0 per cent notional sale cost, net equity is 65.0 and the promote 2.92 instead of 2.68: 0.24 moves from the investor to the sponsor on one line of drafting. The costs are notional because nothing is sold, but the waterfall is meant to replicate a sale, so the agreement should state whether they are deducted rather than leave it to the day. The second mistake is to roll the promote without noticing that the new investor's pref now runs on it, which resets the hurdle at a stabilised value and makes a second promote far harder to earn.
Crystallise by running the existing waterfall at the agreed value, net of notional costs: 2.68 of promote and an 8.79 position here. Then decide between cash and roll knowing that the new hurdle starts at 63.8, not 40.0. The article on valuing a promote before exit prices the claim the recap converts into cash, and the free workbook for this case holds a full promote waterfall to run your own recapitalisation through. Figures are illustrative and this is not investment advice.
Cash removes risk and lifts the IRR; rolling keeps more exposure to the upside. In the illustrative case, taking the $2.68m promote in cash gives the sponsor $10.69m in total and an 18.79 per cent IRR on a $140.0m exit; rolling the full $8.79m gives $11.52m and 16.32 per cent. If the exit is only $120.0m, both routes give $8.79m, because the value is locked in at the recap.
Because the hurdle resets on the recapitalised equity, not the original. The new pref of 8 per cent runs on $63.8m from year three, so year seven equity must exceed $86.80m, an exit of about $143.2m, before any new promote is paid. At the illustrative $140.0m exit, net equity grows 7.0 per cent a year and the new promote is zero.
Usually yes, since the waterfall is meant to replicate a sale, and the agreement should say so. Without the 1 per cent notional cost, net equity at the illustrative $120.0m value is $65.0m instead of $63.8m and the promote rises from $2.68m to $2.92m, so $0.24m of the investor's money turns on one line of drafting.
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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