The order in which a JV applies interim distributions, and why it only matters when the preferred return does not compound.
It depends on the agreement, and it only matters if the preferred return is simple rather than compounding. On an illustrative JV with 10,000,000 of LP equity, an 8 per cent simple pref and two interim distributions, paying accrued pref before capital leaves an LP hurdle of 9,614,080 at sale, against 9,120,000 if capital goes first. On a 12,000,000 sale that cuts the sponsor's 20 per cent promote from 576,000 to 477,184.
Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A waterfall usually lists its tiers as return of capital, then preferred return, then catch-up and promote. That list describes the final settlement. It does not say how a distribution made in year 2, from a refinancing or a partial sale, is applied while the deal is still running. Some agreements apply interim cash to accrued and unpaid pref first, then to capital. Others return capital first. When the pref is a simple percentage of unreturned capital, the two orders produce different hurdles, because one leaves more capital outstanding for the pref to accrue on.
| Input | Value |
|---|---|
| LP equity contributed at the start | 10,000,000 |
| Preferred return, simple, on unreturned capital | 8% a year |
| Distribution at the end of year 2 (refinancing) | 3,000,000 |
| Distribution at the end of year 3 (operations) | 1,000,000 |
| Net sale proceeds to equity, end of year 5 | 12,000,000 |
| Promote above the hurdle, no catch-up | 20% |
The deal returns 16,000,000 on 10,000,000, a 1.60x multiple and an 11.76 per cent gross equity IRR, comfortably above the hurdle either way.
Each year: pref accrued += unreturned capital × 8%
Pref first: paid to pref = MIN(distribution, accrued pref); to capital = MIN(rest, unreturned capital)
Capital first: to capital = MIN(distribution, unreturned capital); paid to pref = MIN(rest, accrued pref)
Hurdle at sale = unreturned capital + accrued unpaid pref; promote = 20% × MAX(0, proceeds − hurdle)
Years 1 and 2 are the same under both orders. The pref accrues 800,000 a year on 10,000,000, so 1,600,000 is owed when the 3,000,000 arrives.
Pref first. The 3,000,000 pays the 1,600,000 of pref and returns 1,400,000 of capital, leaving 8,600,000. Year 3 accrues 688,000; the 1,000,000 pays it and returns 312,000, leaving 8,288,000. Years 4 and 5 accrue 663,040 each. At sale the LP is owed 8,288,000 of capital and 1,326,080 of pref: 9,614,080.
Capital first. The 3,000,000 goes to capital, leaving 7,000,000, and the 1,600,000 of pref stays owed. Year 3 accrues 560,000 on the smaller base; the 1,000,000 also goes to capital, leaving 6,000,000. Years 4 and 5 accrue 480,000 each. At sale the LP is owed 6,000,000 of capital and 3,120,000 of pref: 9,120,000.
| Ordering | Pref earned over the deal | Hurdle at sale | Excess over hurdle | Promote | LP net IRR |
|---|---|---|---|---|---|
| Simple pref, pref first | 3,614,080 | 9,614,080 | 2,385,920 | 477,184 | 11.01% |
| Simple pref, capital first | 3,120,000 | 9,120,000 | 2,880,000 | 576,000 | 10.85% |
| Compounding pref, either order | 9,747,745 | 2,252,255 | 450,451 | 11.05% |
Capital-first ordering lowers the LP's hurdle by 494,080 and raises the promote by 98,816, about 16 basis points of LP IRR. The mechanism is simple: once capital is repaid, the pref stops accruing on it, while the pref left unpaid accrues nothing because a simple pref does not compound. Pref-first ordering keeps capital outstanding longer and so earns more pref, which brings a simple pref much closer to the compounding result.
With a compounding pref the label on each distribution is irrelevant. The balance grows to 11,664,000 by the end of year 2, falls to 8,664,000 after the first distribution, grows to 9,357,120 and falls to 8,357,120 after the second, and reaches 9,747,745 at sale whichever way the cash was booked.
| Year-2 distribution | Pref first | Capital first | Compounding | Gap | Extra promote, capital first |
|---|---|---|---|---|---|
| 0 | 13,000,000 | 12,840,000 | 13,526,881 | 160,000 | 0 |
| 1,600,000 | 11,368,000 | 10,856,000 | 11,511,342 | 512,000 | 102,400 |
| 3,000,000 | 9,614,080 | 9,120,000 | 9,747,745 | 494,080 | 98,816 |
| 5,000,000 | 7,108,480 | 6,640,000 | 7,228,321 | 468,480 | 93,696 |
The gap is largest when the early distribution roughly equals the accrued pref, 1,600,000 here: under pref first it all goes to pref and capital stays whole, while under capital first it all goes to capital. With no year-2 distribution the hurdle exceeds the 12,000,000 of proceeds under every method, so no promote is paid and the ordering changes nothing for the sponsor.
Modelling the waterfall only at exit, as one lump of proceeds run through the tiers, and assuming that is how the agreement works. A model that ignores how interim distributions are applied will compute the wrong hurdle whenever a refinancing or partial sale returns cash before the end. The reverse mistake is arguing hard over the order in an agreement whose pref compounds, where it changes nothing.
Illustrative figures. Real agreements may also apply interim cash to the sponsor's co-invest pro rata, add a catch-up or calculate the pref daily; the ordering effect works the same way.
If the pref is simple, the order matters: pref first lifts the LP hurdle on this deal from 9,120,000 to 9,614,080 and cuts the promote by 98,816. If it compounds, it does not. Check which you have before modelling the interim distributions. Chapter 12 of the book works two waterfalls, and the free workbooks for the book reproduce both tier by tier. See also how to calculate the preferred return in a fund and what quarterly compounding adds to a pref.
Many real estate JV agreements apply interim distributions to accrued and unpaid preferred return first and then to capital, while whole-fund European waterfalls usually return capital first. Read the clause: on the worked deal the choice moves the LP's hurdle at sale by 494,080 on 10,000,000 of equity when the pref is simple.
Because a compounding pref accrues on capital and unpaid pref together, so any distribution reduces the same balance whatever it is labelled. In the worked case the balance is 11,664,000 after two years, 8,664,000 after the first distribution and 9,747,745 at sale under either order.
The sponsor. Returning capital first shrinks the base on which a simple pref accrues, while the unpaid pref sits in the account earning nothing. On the worked deal the LP earns 3,120,000 of pref instead of 3,614,080, and the sponsor's promote rises from 477,184 to 576,000.
This article is one calculation from Private Equity Real Estate. 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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