A year 3 cash-out refinancing run through an illustrative 90/10 joint venture waterfall, capital account by capital account.
Refinance proceeds go through the same waterfall as sale proceeds: first to the partners until the investor's capital and accrued preferred return are repaid, then into the promote split. On an illustrative 50.0 million joint venture that refinances in year 3 and distributes 70.0, 57.37 clears the capital account and the remaining 15.13 is split 72/28, paying the sponsor a promote of 3.03 at the refinancing. Because the preferred return stops accruing once capital is back, the same 85.0 of refinance and sale proceeds pays 6.63 of promote in total against 4.82 without a refinancing.
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 →
An investor puts up 45.0 and a sponsor 5.0 of a 50.0 equity cheque, 90/10. The property pays 2.5 a year to equity for three years. At the end of year 3 the partners refinance at the higher value the business plan has created and distribute 70.0 of net proceeds; with more interest to pay, operating distributions fall to 1.5 a year, and a sale at the end of year 5 returns 15.0 of equity. All figures are illustrative, in millions.
| Tier | Until | Investor | Sponsor |
|---|---|---|---|
| 1. Capital and preferred return | Capital plus 8% compounded annually is repaid | 90% | 10% |
| 2. Promote, 20% | Thereafter | 72% | 28% |
The sponsor's 28 per cent in tier 2 is its 20 per cent promote plus 10 per cent of the remaining 80.
Keep a capital account: open with contributed capital, accrue 8 per cent each year, deduct each distribution that goes to tier 1. Whatever a distribution leaves after the account is cleared goes to tier 2.
Accountt = Accountt−1 × 1.08 − tier 1 distributiont
Tier 1t = MIN(distributiont, Accountt−1 × 1.08); tier 2t = distributiont − tier 1t
Excel: =MIN(D5,B5*1.08) for tier 1, =D5-E5 for tier 2
| Year | Opening account | 8% accrual | Distribution | Tier 1 | Tier 2 | Promote | Closing account |
|---|---|---|---|---|---|---|---|
| 1 | 50.00 | 4.00 | 2.50 | 2.50 | 0.00 | 0.00 | 51.50 |
| 2 | 51.50 | 4.12 | 2.50 | 2.50 | 0.00 | 0.00 | 53.12 |
| 3 | 53.12 | 4.25 | 72.50 | 57.37 | 15.13 | 3.03 | 0.00 |
| 4 | 0.00 | 0.00 | 1.50 | 0.00 | 1.50 | 0.30 | 0.00 |
| 5 | 0.00 | 0.00 | 16.50 | 0.00 | 16.50 | 3.30 | 0.00 |
| Total | 95.50 | 6.63 |
In year 3 the 72.50 distributed, the 2.5 of operations plus the 70.0 of refinancing, first clears the 57.37 owed under tier 1. The investor receives 62.53 that year and the sponsor 9.97, of which 3.03 is promote. From then on the account is zero and stays zero, so every later distribution, operating cash flow included, is split 72/28.
The deal returns 95.50 on 50.0, a 22.34 per cent IRR and 1.91 times. The investor earns 19.93 per cent and 1.78 times; the sponsor 39.22 per cent and 3.10 times on its 5.0. Of the 6.63 of promote, 46 per cent is paid at the refinancing, two years before anyone knows what the sale will fetch.
Hold the combined refinance and sale proceeds at 85.0, and the operating distributions as above, and move only the split between them.
| Refinance proceeds | Exit equity | Account after refinancing | Promote at refinancing | Total promote | Investor IRR | Sponsor IRR |
|---|---|---|---|---|---|---|
| 0.0 | 85.0 | 54.87 | 0.00 | 4.82 | 13.56% | 23.95% |
| 30.0 | 55.0 | 24.87 | 0.00 | 5.82 | 15.87% | 28.75% |
| 50.0 | 35.0 | 4.87 | 0.00 | 6.49 | 17.83% | 32.22% |
| 60.0 | 25.0 | 0.00 | 1.03 | 6.63 | 18.87% | 35.14% |
| 70.0 | 15.0 | 0.00 | 3.03 | 6.63 | 19.93% | 39.22% |
Total promote rises by 1.80, 37 per cent, between no refinancing and a refinancing that clears the account, with no more cash in nominal terms. The reason is the preferred return: it accrues only on capital still outstanding, so every unit returned early stops costing the sponsor 8 per cent a year. Beyond the point where the account is cleared, a larger refinancing no longer changes the total promote, only its timing, and the sponsor's IRR keeps rising because it is paid sooner. The investor's IRR rises too, which is why a refinancing is rarely resisted. What the investor gives up is protection: once the account is zero, a weak sale pays the sponsor its promote anyway, unless the agreement has a lookback.
The common mistake is to model the preferred return as simple interest on contributed capital for the whole hold, a hurdle of 70.0 here, and promote everything above it at the end. That gives 5.10, understating the sponsor's entitlement by 1.53 and putting all of it in year 5, when the agreement pays 3.03 in year 3. The second mistake runs the other way: treating the refinancing as a return of capital outside the waterfall, split 90/10, which defers the promote entirely. Read the distribution clause: many define "capital proceeds" to include refinancing and send them through the full waterfall.
For the deal-level effect of the same refinancing on IRR and multiple, see how a cash-out refinance changes IRR and equity multiple; for a waterfall with more tiers, the multi-tier IRR waterfall. The complete venture of the book, refinancing and lookback included, is in the free workbooks for Real Estate Joint Ventures.
Usually yes, if the proceeds exceed what tier 1 still owes. On an illustrative 50.0 joint venture, a 70.0 refinancing in year 3 meets a capital account of 57.37 (capital plus 8 per cent preferred return, less distributions), and the 15.13 left over is split 72/28, paying the sponsor a promote of 3.03. A refinancing of 50.0 would pay none and leave 4.87 owing.
Only on capital still outstanding. Once refinance proceeds clear the capital account, nothing accrues, and every later distribution, operating cash flow included, falls into the promote tier. That is why a refinancing that clears the account raises total promote from 4.82 to 6.63 in the illustrative case without any extra cash.
Because the money comes back earlier. Holding refinance and sale proceeds together at 85.0, moving 70.0 into year 3 lifts the investor's IRR from 13.56 to 19.93 per cent, even though the sponsor's promote rises from 4.82 to 6.63. The cost to the investor is not return but protection, since the promote is paid before the sale price is known.
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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