A sponsor that subordinates its co-invest writes the investor a put on the downside and gives up nothing on the upside.
Run the waterfall both ways at each possible exit value and take the difference. In an illustrative 50,000,000 venture where the sponsor puts up 10 per cent, subordinating the sponsor's capital moves money to the investor only below the preferred return: up to 6,611,976, 1.32 times the sponsor's own capital, and nothing once proceeds reach 73,466,404. Weighted across five outcomes, the investor gains 3,335,929 and the sponsor's expected multiple on its co-invest halves.
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 commits 45,000,000 and a sponsor 5,000,000 to a five-year venture. The property is sold at the end and, to keep the arithmetic visible, everything is distributed then. The investor asks for its money back first: it wants the sponsor's co-invest to be a first loss, not a parallel stake. All terms are illustrative.
| Item | Value |
|---|---|
| Total equity | 50,000,000 |
| Investor / sponsor | 45,000,000 / 5,000,000 |
| Preferred return, compounded annually | 8.0% |
| Promote above the pref | 20.0% |
| Hold | 5 years |
Pref factor = 1.085 = 1.4693
Investor hurdle = 45,000,000 × 1.4693 = 66,119,763
Sponsor hurdle = 5,000,000 × 1.4693 = 7,346,640
Pari passu: investor reaches its hurdle at 66,119,763 / 0.9 = 73,466,404 of proceeds
Subordinated: both hurdles are met at 66,119,763 + 7,346,640 = 73,466,404
The two thresholds are the same number, total equity times 1.4693, and that is the whole result in one line. Above 73,466,404 the two waterfalls are identical, so the promote and every party's return are untouched. Below it, subordination moves money from the sponsor to the investor. In Excel the subordinated investor's take is =MIN(X,InvHurdle)+MAX(0,X-InvHurdle-SpHurdle)*0.72.
| Deal multiple | Proceeds | Investor, pari passu | Investor, subordinated | Moved to investor | Investor IRR pari / sub |
|---|---|---|---|---|---|
| 0.60x | 30,000,000 | 27,000,000 | 30,000,000 | 3,000,000 | -9.7% / -7.8% |
| 0.80x | 40,000,000 | 36,000,000 | 40,000,000 | 4,000,000 | -4.4% / -2.3% |
| 1.00x | 50,000,000 | 45,000,000 | 50,000,000 | 5,000,000 | 0.0% / 2.1% |
| 1.20x | 60,000,000 | 54,000,000 | 60,000,000 | 6,000,000 | 3.7% / 5.9% |
| 1.32x | 66,119,763 | 59,507,787 | 66,119,763 | 6,611,976 | 5.7% / 8.0% |
| 1.40x | 70,000,000 | 63,000,000 | 66,119,763 | 3,119,763 | 7.0% / 8.0% |
| 1.60x | 80,000,000 | 70,823,953 | 70,823,953 | 0 | 9.5% / 9.5% |
| 1.80x | 90,000,000 | 78,023,953 | 78,023,953 | 0 | 11.6% / 11.6% |
The transfer rises with proceeds, peaks at 6,611,976 exactly where the investor reaches its hurdle, then falls to zero by 73,466,404. Under subordination the investor is made whole at a 0.90x deal instead of 1.00x. The sponsor gets nothing at all until the deal returns 1.32x.
Seen from the sponsor's side the asymmetry is stark. At a 0.80x exit the pari passu sponsor gets back 4,000,000 and loses 4.4 per cent a year, the same as the investor. The subordinated sponsor loses all 5,000,000. At 1.40x it recovers 3,880,237, still below its capital, while the investor already has its full 8 per cent. Only from 1.47x, 73,466,404 of proceeds, is the sponsor indifferent between the two documents; at 1.60x it receives 9,176,047 and a 12.9 per cent IRR under either.
A single scenario tells you little, because the transfer depends on where the exit lands. Weight a set of outcomes. The probabilities below are illustrative and give an expected deal multiple of 1.240x.
| Deal multiple | Probability | Investor, pari passu | Investor, subordinated | Moved |
|---|---|---|---|---|
| 0.70x | 10% | 31,500,000 | 35,000,000 | 3,500,000 |
| 0.90x | 15% | 40,500,000 | 45,000,000 | 4,500,000 |
| 1.10x | 25% | 49,500,000 | 55,000,000 | 5,500,000 |
| 1.40x | 30% | 63,000,000 | 66,119,763 | 3,119,763 |
| 1.70x | 20% | 74,423,953 | 74,423,953 | 0 |
| Expected | 55,384,791 | 58,720,720 | 3,335,929 |
The investor's expected multiple rises from 1.231x to 1.305x. The sponsor's expected proceeds fall from 6,615,209 to 3,279,280: from 1.32x its capital to 0.66x. The expected transfer is 66.7 per cent of the sponsor's co-invest, and 7.41 per cent of the investor's equity. Subordination is a put option the sponsor writes on the venture, struck at the investor's hurdle, and it is not cheap.
Sponsors offer subordination as a sign of conviction, and investors accept it as costless comfort, because in the base case nothing changes: at a 1.60x exit both waterfalls give identical answers. The cost sits entirely in the outcomes nobody models in the term sheet discussion. A sponsor that subordinates should be paid for it, in a higher promote, a lower pref or a promote that starts earlier, and the price is the expected transfer, not the base case. The investor should also check the reverse: a subordinated sponsor with a promote that pays above 73,466,404 has a sharper incentive to take risk, because its downside is already gone in the weak cases. For how the promote itself moves the investor's return, see how much the promote reduces investor IRR.
With interim distributions the logic is the same, but the hurdle balances must be rolled forward each year net of what each partner has received, so the threshold moves with the timing of cash.
The book covers sponsor co-investment, alignment and the promote waterfall, and the free workbook for this case lets you rerun the waterfall on other terms. For the sponsor's return on its co-invest with a promote, see what IRR a sponsor earns on its co-invest.
The investor receives its capital and preferred return before the sponsor receives anything back on its own co-invest. In the illustrative case the investor's 45,000,000 is made whole at 45,000,000 of proceeds, a 0.90x deal, instead of at 50,000,000 when the two invest pari passu. The sponsor's 5,000,000 is the first loss.
No, as long as the promote starts only after both partners reach the pref. Both waterfalls reach that point at the same proceeds, 73,466,404 here, and are identical above it. At 1.60x the investor receives 70,823,953 under either structure. Subordination moves money only in the band below the hurdle.
Price the expected transfer. With the illustrative outcome probabilities used here the investor gains 3,335,929, 66.7 per cent of the sponsor's capital, and the sponsor's expected multiple on its co-invest falls from 1.32x to 0.66x. A sponsor that offers subordination should expect a higher promote or a lower pref in exchange.
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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