A structured preferred offers a co-investor downside protection; the break-even against common equity is simpler than it looks.
A non-participating preferred beats common equity in a co-investment only when the deal's equity IRR ends up below the preferred rate. In an illustrative 100 co-investment in a 500 equity cheque held five years, an 11 per cent compounding preferred is worth 168.5 at exit, and common only overtakes it above 842.5 of exit equity, a 1.69x deal, which is exactly an 11.0 per cent equity IRR. Below that line the preferred wins; above it every extra turn of value goes to the fund, which holds the ordinary equity.
Worked in full in The Co-Investment Practitioner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most co-investments are common equity alongside the fund, on the same terms and at the same price. But when a sponsor needs to fill an equity gap late, or a co-investor is more cautious than the fund, the offer sometimes comes as a structured instrument: a preferred share or shareholder loan that accrues a fixed return, ranks ahead of the ordinary equity and is redeemed at exit. The question is simple to state. Is a certain-looking 11 per cent worth more than a pro rata share of the upside?
| Input | Value |
|---|---|
| Total equity cheque at entry | 500 |
| Fund's equity | 400 |
| Co-investor's cheque | 100 |
| Option A: common, pari passu with the fund | 20.0% of equity |
| Option B: preferred, compounding, non-participating | 11.0% a year |
| Option C: preferred at 8.0% plus a kicker on the residual equity | 5.0% of residual |
| Holding period, years | 5 |
In options B and C the fund holds all of the ordinary equity, apart from the kicker. Exit equity means the value of all equity after repaying the company's debt.
Preferred claim at exit = 100 × 1.115 = 168.5
Common payoff = 20.0% × exit equity
Break-even exit equity = 168.5 / 20.0% = 842.5, a deal multiple of 1.685x
Deal equity IRR at that exit = 1.6851/5 − 1 = 11.0%, the preferred rate
Excel: =Coinv*(1+Rate)^Years/Share for the break-even exit equity
The last line is the useful rule. A pari passu common stake earns exactly the deal's equity return, so a non-participating preferred at rate r beats it whenever the deal earns less than r, and loses to it whenever the deal earns more. The co-investor is not choosing between instruments; it is betting on whether the deal clears 11 per cent.
| Exit equity | Deal multiple | A: common | B: pref 11% | C: pref 8% + kicker |
|---|---|---|---|---|
| 250 | 0.50x | 50.0 (−12.9%) | 168.5 (11.0%) | 152.1 (8.7%) |
| 500 | 1.00x | 100.0 (0.0%) | 168.5 (11.0%) | 164.6 (10.5%) |
| 750 | 1.50x | 150.0 (8.4%) | 168.5 (11.0%) | 177.1 (12.1%) |
| 842.5 | 1.69x | 168.5 (11.0%) | 168.5 (11.0%) | 181.7 (12.7%) |
| 1,000 | 2.00x | 200.0 (14.9%) | 168.5 (11.0%) | 189.6 (13.6%) |
| 1,250 | 2.50x | 250.0 (20.1%) | 168.5 (11.0%) | 202.1 (15.1%) |
The preferred is paid in full as long as exit equity is at least 168.5, which is 33.7 per cent of the entry equity: the company's equity can lose two thirds of its value before the co-investor misses a cent of its accrued return. That protection is what it costs to give up the upside. At a 2.50x deal, the kind of base case a sponsor might show an investment committee, the common holder receives 250.0 against 168.5, a gap of 81.5. At a flat 1.00x deal, the preferred is ahead by 68.5.
The kicker structure in option C sits between the two. It accrues less, 146.9 at exit, but takes 5.0 per cent of whatever is left above it. Its break-even against common moves to 930.6 of exit equity, a 1.86x deal and a 13.2 per cent equity IRR, and it beats the plain preferred once exit equity passes 578.4, a 1.16x deal, because 5.0 per cent of the residual then outweighs the 21.6 of accrual it gave up.
The preferred is not free value; it is leverage for the fund. With everyone in common, the fund's multiple runs from 1.00x at a 500 exit to 2.50x at 1,250. With the co-investor in preferred, the same range becomes 0.83x to 2.70x: the fund's ordinary equity is now subordinated to a fixed claim. A sponsor that offers co-investors a senior instrument is moving risk onto its own fund investors, and an LP that is both a fund investor and a co-investor in the same deal should ask how that conflict was cleared before celebrating the downside protection.
Comparing the preferred rate with the sponsor's target return. If the base case shows 2.50x and 20.1 per cent, an 11 per cent preferred looks like a poor trade, and the analysis often stops there. The correct comparison is with the distribution of outcomes the co-investor itself believes, and in particular with the probability that the deal earns less than 11 per cent. Adverse selection is the reason to take that tail seriously: the deals offered for co-investment are not always the ones the sponsor most wants to hold in full, as how much worse co-investment deals can be and still beat the fund sets out. A second mistake is to treat the preferred as risk-free: below 168.5 of exit equity it shares the loss, and below 100 it loses principal, so it is a senior equity claim with a capped payoff, not a loan with covenants.
If a management incentive plan sits in the ordinary equity, it dilutes option A and leaves option B untouched, which moves the break-even further in favour of the preferred; see how much a management incentive plan dilutes a co-investor. The book's own workbooks and checklists for underwriting a co-investment are on the free companion page.
Write down the deal equity IRR at which you would be indifferent, and it is the preferred rate itself. Here that is 11.0 per cent, a 1.69x deal over five years. Take the preferred if you think the deal has a real chance of missing that; take the common if you underwrite it comfortably above. A kicker buys back some of the upside and moves the line to 13.2 per cent.
When the deal's equity IRR exceeds the preferred rate, for a non-participating preferred that compounds and is redeemed at exit. In the illustrative case an 11 per cent preferred on a 100 cheque is worth 168.5 after five years, and a 20 per cent common stake reaches that only at 842.5 of exit equity, a 1.69x deal earning 11.0 per cent a year.
It is paid in full as long as exit equity covers its accrued claim. With 168.5 owed on a 500 equity cheque, equity can fall to 33.7 per cent of its entry value before the preferred misses any of its return. Below 100 of exit equity it loses principal, so it is a senior equity claim, not a secured loan.
It levers the fund's ordinary equity. In the illustrative case the fund's multiple ranges from 1.00x to 2.50x across a 500 to 1,250 exit if all investors hold common, and from 0.83x to 2.70x if the co-investor holds an 11 per cent preferred. Fund investors take more risk for more upside, which is a conflict worth asking the sponsor about.
This article is one calculation from The Co-Investment Practitioner. 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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