The promote is paid on the investors' capital but lands on the sponsor's small cheque, which is why the sponsor's IRR moves so much faster than the deal's.
Run the waterfall year by year and take the IRR of what the sponsor actually receives, co-invest share plus promote, against what it actually put in. In an illustrative $20,000,000 joint venture with 10 per cent sponsor co-invest, an 8 per cent preferred return and a 20 per cent promote, a deal returning 12.26 per cent gives the sponsor 18.56 per cent and a 2.21x multiple, and the investor 11.46 per cent.
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 →
The gap is the point of the structure, and it is larger than most first-time sponsors expect. The promote is calculated on the whole partnership's profit, but it lands on the sponsor's own cheque, which is a tenth of the equity. Small numbers on a small denominator produce large percentages.
| Input | Value |
|---|---|
| Total equity | 20,000,000 |
| Investor (LP) 90% / sponsor co-invest 10% | 18,000,000 / 2,000,000 |
| Cash distributions, years 1 to 5 | 1,200,000 a year |
| Net sale proceeds, end of year 5 | 28,000,000 |
| Tier 1: pro rata until the LP earns | 8% IRR |
| Tier 2: promote 20% until the LP earns | 12% IRR |
| Tier 3: promote thereafter | 30% |
The deal itself returns 12.26 per cent at a 1.70x multiple: $34,000,000 distributed on $20,000,000, a profit of $14,000,000.
Sponsor share of a tier = promote + co-invest share × (1 − promote)
Tier 2: 20% + 10% × 80% = 28%. Tier 3: 30% + 10% × 70% = 37%
Track the hurdle as a balance: the LP's capital compounds at 8 per cent each year and every dollar the LP receives reduces it. Cash goes to tier 1 until the balance is zero, then to tier 2 against a second balance compounding at 12 per cent. In Excel, each tier is a MIN of the cash left and the cash needed to clear that tier's balance, grossed up by the LP's share: =MIN(Cash_Left, Hurdle_Balance/LP_Share).
In years 1 to 4, the $1,200,000 of income is well short of 8 per cent on the LP's capital, so it is split 90/10: $1,080,000 to the LP and $120,000 to the sponsor, and the LP's 8 per cent balance keeps growing. In year 5 the $29,200,000 clears the balance, then runs into tier 2 and pays the sponsor 28 per cent of what is left. The 12 per cent balance is not cleared, so tier 3 is never reached.
| Year | Deal | LP | Sponsor |
|---|---|---|---|
| 0 | −20,000,000 | −18,000,000 | −2,000,000 |
| 1 to 4, each | 1,200,000 | 1,080,000 | 120,000 |
| 5 | 29,200,000 | 25,262,395 | 3,937,605 |
| Total received | 34,000,000 | 29,582,395 | 4,417,605 |
| IRR | 12.26% | 11.46% | 18.56% |
| Multiple | 1.70x | 1.64x | 2.21x |
The sponsor's $4,417,605 splits into $3,286,933 of pro-rata return on its own capital and a $1,130,672 promote. The promote is 8.1 per cent of the deal's profit, and it takes the sponsor's share of profit from 10 per cent to 17.3 per cent. In IRR terms, the sponsor gains 6.30 points over the deal and the LP gives up 0.80 points. The asymmetry is the ratio of the two cheques: the same dollars are spread across $18,000,000 on one side and $2,000,000 on the other.
Note how far the 8.1 per cent sits below the headline 20 per cent. This venture has no catch-up, so the promote applies only to cash above the 8 per cent pref. A fund waterfall with a full catch-up works the other way and can pay the manager more than 20 per cent of profit, as shown in what a 20 per cent promote actually pays; the question here is different: not how big the promote is, but what it does to the return on the sponsor's own cheque.
| Net sale | Deal IRR | LP IRR | Sponsor IRR | Sponsor multiple | Promote |
|---|---|---|---|---|---|
| 22,000,000 | 7.71% | 7.71% | 7.71% | 1.40x | 0 |
| 25,000,000 | 10.09% | 9.68% | 13.47% | 1.79x | 530,672 |
| 28,000,000 | 12.26% | 11.46% | 18.56% | 2.21x | 1,130,672 |
| 31,000,000 | 14.28% | 12.99% | 23.75% | 2.72x | 1,936,411 |
Below the 8 per cent pref there is no promote and all three IRRs are identical. Above it, each $3,000,000 on the sale moves the deal by about two points and the sponsor by about five. At $31,000,000 the LP clears 12 per cent, tier 3 opens and the sponsor's take rises to 37 per cent of the last dollars.
| Sponsor co-invest | Sponsor IRR | LP IRR | Promote |
|---|---|---|---|
| 2% | 36.78% | 11.46% | 1,130,672 |
| 5% | 24.23% | 11.46% | 1,130,672 |
| 10% | 18.56% | 11.46% | 1,130,672 |
| 20% | 15.24% | 11.46% | 1,130,672 |
The promote and the LP's return do not change with the co-invest share: the hurdles are measured on the partnership's capital, and the promote is a fixed slice of the same profit. Only the sponsor's denominator moves. A 2 per cent co-invest turns the same deal into a 36.78 per cent sponsor IRR, which is why investors ask for meaningful co-invest: it is the only part of the sponsor's return exposed to the downside.
The common mistake is to report the sponsor's IRR as if it were a measure of skill or of risk taken. It is neither. It is mostly a function of how little the sponsor put in. The honest presentation separates the two streams: the co-invest earns the deal IRR, 12.26 per cent here, and the promote is a fee for performance, $1,130,672, best read as a share of profit, 8.1 per cent. The second mistake is to model the tiers on the deal IRR instead of the LP IRR. The deal here returns 12.26 per cent, above the 12 per cent second hurdle, but after the promote the LP earns 11.46 per cent, so tier 3 never opens. A model that tests the deal IRR would pay a 30 per cent promote that the agreement does not owe.
How the order of payment changes who carries the risk is worked in the European versus American waterfall, and the choice of hurdle metric in IRR hurdle versus equity multiple hurdle.
The sponsor's IRR is the deal IRR plus a promote divided by a small number. On this venture a 12.26 per cent deal pays the sponsor 18.56 per cent and the LP 11.46 per cent, and the gap is set as much by the 10 per cent co-invest as by the deal. The free workbooks for this book run the waterfalls tier by tier, with the blank set ready for your own terms.
Run the waterfall year by year: pay distributions pro rata until the LP's capital has earned the preferred return, then split the next tier so the sponsor receives its promote plus its pro-rata share of the rest. With 10 per cent co-invest and a 20 per cent promote, the sponsor takes 28 per cent of tier-two cash. On the illustrative deal the promote is $1,130,672.
Because the promote is earned on the LP's capital but measured against the sponsor's much smaller co-invest. On the illustrative deal a 12.26 per cent property return becomes 18.56 per cent for a sponsor with 10 per cent co-invest, and 36.78 per cent for one with 2 per cent, while the LP's 11.46 per cent is the same in every case.
No. Below the preferred return every dollar is split pro rata, so the sponsor earns exactly the deal IRR. On the illustrative venture, a $22,000,000 sale gives a 7.71 per cent deal IRR, under the 8 per cent pref, and the sponsor, the LP and the deal all earn 7.71 per cent with no promote.
Chapters 11 and 12 of Private Equity Real Estate set out the waterfall, the preferred return and the promote; the free companion workbook works both of the book's waterfalls tier by tier. 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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