Rescue capital's priority return moves the point at which the promote pays. A preferred return reset moves it back, at a price.
Rescue capital is repaid with its priority return before the original partners see anything, so it raises the exit value at which the sponsor's promote starts to pay. In an illustrative JV, 20 of rescue at 12 per cent for three years takes 28.10 off the top of a 200 exit, and the sponsor's promote falls to 4.99, with no promote at all below 175.03. Resetting the preferred return to the rescue date restores it to 9.19, and moves 3.77 from the investor to 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 →
A venture has 100 of equity, 90 from an institutional investor and 10 from the sponsor. The preferred return is 8 per cent, compounding annually on unreturned capital, and above it the sponsor takes a 20 per cent promote on the residual, with the rest split 90/10. At the end of year 2 the venture needs 20 more: a cost overrun, a leasing package or a loan paydown. The sponsor cannot fund its share. The investor agrees to provide all 20 as rescue capital, repaid first at 12 per cent compounding, and distributions are suspended until exit in year 5. All figures are illustrative, in millions.
| Term | Value |
|---|---|
| Original equity (investor 90, sponsor 10) | 100 |
| Preferred return, compounding | 8% |
| Promote on the residual | 20% |
| Rescue capital, end of year 2, from the investor | 20 |
| Rescue return, compounding, repaid first | 12% |
| Exit, end of year 5, equity proceeds | 200 |
Rescue repayment = rescue × (1 + rescue rate)years outstanding
Hurdle = original equity × (1 + pref)years from the pref start
Promote = 20% × (proceeds − rescue repayment − hurdle), if positive
Excel: =MAX(0,20%*(200-20*(1+12%)^3-100*(1+8%)^5))
Step 1, the rescue comes out first. 20 × 1.123 = 20 × 1.4049 = 28.10, of which 8.10 is its return. That leaves 171.90 for the original partners.
Step 2, capital and preferred return. 100 × 1.085 = 146.93: the original 100 plus 46.93 of accrued preferred return, paid 90/10.
Step 3, the residual. 171.90 less 146.93 leaves 24.97. The sponsor's promote is 20 per cent of it, 4.99, and the remaining 19.98 is split 90/10.
Step 4, the totals. The investor receives 178.32 on its 90 and 20, an IRR of 10.91 per cent. The sponsor receives 21.68 on its 10, an IRR of 16.74 per cent.
The promote starts paying only when proceeds exceed 28.10 plus 146.93, which is 175.03. A sponsor that was comfortably in the money on the original plan can find itself working for its 10 per cent share alone after a rescue, and that is when sponsors stop pushing.
Investors sometimes trade a reset for the sponsor's cooperation: the hurdle on the original 100 restarts at the rescue date, so it accrues for three years instead of five. The accrued pref falls from 46.93 to 25.97, as 100 × 1.083 is 125.97.
| Structure | Rescue repaid | Hurdle | Promote | Investor | Sponsor | Investor IRR | Sponsor IRR |
|---|---|---|---|---|---|---|---|
| Rescue at 12%, repaid first | 28.10 | 146.93 | 4.99 | 178.32 | 21.68 | 10.91% | 16.74% |
| Same, pref reset at year 2 | 28.10 | 125.97 | 9.19 | 174.54 | 25.46 | 10.40% | 20.55% |
| Investor funds 20 as ordinary capital | 0.00 | 172.13 | 5.57 | 177.87 | 22.13 | 10.85% | 17.21% |
The reset multiplies the promote by 1.84 and costs the investor 3.77, about half a point of IRR. The third line is the alternative of funding the 20 as ordinary capital, earning the 8 per cent pref and diluting the sponsor to a 91.67 per cent investor share of the residual. At a 200 exit it lands within 0.06 points of the priority structure; the difference is in the tails.
| Exit proceeds | Promote, rescue | Promote, with reset | Investor IRR, rescue | Investor IRR, reset | Investor IRR, ordinary capital |
|---|---|---|---|---|---|
| 150 | 0.00 | 0.00 | 4.97% | 4.97% | 4.87% |
| 175 | 0.00 | 4.19 | 8.42% | 7.87% | 8.31% |
| 200 | 4.99 | 9.19 | 10.91% | 10.40% | 10.85% |
| 225 | 9.99 | 14.19 | 13.20% | 12.74% | 13.19% |
| 250 | 14.99 | 19.19 | 15.33% | 14.90% | 15.36% |
The reset is a fixed transfer of 4.19 of promote at every exit above 175.03, and it moves the promote's starting point down to 154.07. At 150 neither structure pays a promote, and the priority return is what protects the investor: 4.97 per cent against 4.87 as ordinary capital. At 250 the ordinary-capital route edges ahead, because the investor's 20 shares in the upside. Rescue capital is downside protection bought with upside.
Negotiating the rescue rate and ignoring the promote. A 12 per cent rescue looks expensive to the sponsor and generous to the investor, but the bigger effect is on incentives: at a 175 exit the sponsor earns no promote without a reset and 4.19 with one. If the investor needs the sponsor to see the business plan through, a partial reset can cost less than a sponsor who has nothing left to win. Whether to give it is a judgment; what it costs is arithmetic, and it should be computed at three or four exit values, not one.
The waterfall engine and the other chapters' arithmetic, including the rescue, are live in the free workbooks for this case. For the threshold calculation on its own, see at what exit price a JV promote starts to pay, and for the other remedy when a partner cannot fund, what a missed capital call costs.
New money put into a venture that needs cash its partners cannot all provide, usually with a priority return and repaid before the original equity. In an illustrative JV, an investor provides 20 at the end of year 2 at 12 per cent compounding. By a year-5 exit it is owed 28.10, which comes out of the proceeds before any capital, preferred return or promote.
An agreement that the preferred return on the original equity restarts from a later date, typically when new money goes in, so less pref accrues before the promote. On 100 of equity at 8 per cent, restarting at year 2 cuts the accrual by year 5 from 46.93 to 25.97. At a 200 exit that raises the sponsor's promote from 4.99 to 9.19.
It protects the downside and gives up some upside. In the illustrative case, funding 20 as priority capital at 12 per cent gives the investor 4.97 per cent at a 150 exit against 4.87 as ordinary capital with an 8 per cent pref, but 15.33 against 15.36 at 250. At 200 the two are within 0.06 points.
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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