Dilution at a fair price costs nothing. What a pay-to-play clause costs is a quarter of a turn across the programme — while making every single deal look obvious.
A co-investment programme puts 100 into ten deals. One of them raises a rescue round at
half the entry mark, and the standard advice applies: hold a reserve, follow your money, do not
let your stake be eroded. The reserve most programmes reach for is fifteen per cent. On these
figures a fifteen per cent reserve is worth 0.019 of a turn of programme
multiple — and at twenty per cent it loses money.
Unless the shareholders’ agreement contains a pay-to-play clause, in which case the
same fifteen per cent is worth 0.285 — fifteen times more, on the same
portfolio, the same companies and the same probabilities. The reserve question turns out not to
be a portfolio question at all.
First, the thing the warning gets wrong
“Your stake will be heavily eroded” is what a co-investor is told. Take the
round at face value and see what the dilution actually does.
The day before the round
The day after, having declined
Your ownership
2.500%
1.667%
Equity value it applies to
200
300
Your value
5.00
5.00
A 10 cheque into a 400 company, marked down to a 200 pre-money and raising 100. The percentage falls by a third and the value does not move at all.
Nothing was taken by the dilution. The percentage fell from 2.50% to 1.67%
and the value stayed at 5.00, because the new money bought exactly what it paid for. What cost
real money was the markdown from 400 to 200, and that hit every holder identically —
the ones who wrote a follow-on cheque and the ones who did not.
So what a non-participant gives up is not value already held. It is the option to buy more
at the marked-down price, and an option has a price rather than a moral weight. Calling it
erosion invites the reflex to defend the percentage, which is the expensive move rather than
the prudent one.
What the option is worth, and the test that decides it
The follow-on cheque is 2.50 and it buys 0.833% of extra ownership, worth 5.83 at a 700 exit. That
is a marginal return of 2.33, and on that number the decision looks settled.
It is not, because the money has an alternative use: another co-investment at the
programme’s own gross. Against a 2.00× alternative the follow-on is the better decision only
above an exit of 600 — 2.00 times the post-money the rescue round
has just set, in a company that missed plan badly enough to need rescuing. Demanding,
and correct.
One deal, at a 700 exit
Plain dilution
Under pay-to-play
Multiple, having followed on
1.40
1.40
Multiple, having declined
1.17
0.50
Return on the follow-on dollars alone
2.33
5.00
Break-even exit equity
600
250
as a multiple of the round’s own post-money
2.00
0.83
Same company, same exit, same capital. One clause different.
Under the punitive clause the same decision is not close. A one-times preference on the
new money and a halving of non-participants’ units take the decliner from 1.17 to
0.50, lift the marginal return to 5.00, and drop the break-even to 250
— 0.83 of the round’s own post-money. You should follow on in almost every
state of the world, and nothing about the company changed to make that true.
The trap, which is at the programme level
Run the ten deals with the whole programme deployed into initial cheques. Under plain
dilution the programme returns 1.667. Under pay-to-play, identical in every other
respect, it returns 1.40.
So the clause that makes every individual follow-on look obvious costs the programme
0.267 of a turn. A practitioner applying the marginal-dollar test deal by deal
will conclude “follow on” every time, and will be right about the margin and
wrong about the position. That is the shape good money after bad actually takes: it never
looks like a bad decision at the margin, because at the margin it is not one.
So how big should the reserve be?
The reserve either covers a draw or it does not, so the question has to be run as an
expectation over the whole distribution of how many deals come back — a step, not a
slope. Every euro held back also shrinks the initial cheque, which shrinks the ownership in the
six deals that never raise at all.
Reserve policy
Initial cheque
Raisers it can fund
Worth, plain dilution
Worth, under pay-to-play
5%
9.50
2
0.029
0.165
9%
9.10
3
0.027
0.219
10%
9.00
4
0.037
0.268
13%
8.70
5
0.027
0.280
15%
8.50
7
0.019
0.285
20%
8.00
10
-0.016
0.251
25%
7.50
10
-0.051
0.216
Turns of programme multiple, against holding no reserve at all. Expectation over the binomial distribution of how many of the ten deals come back — not over the average.
Two readings. Under plain dilution the value peaks around 10% and turns
negative before twenty: past the optimum the reserve is taking capital out of a two-times sleeve
and parking it at 1.09×. Under pay-to-play the optimum is nearer 15% and the whole
curve sits an order of magnitude higher. The optimum is a property of the document, not
of the portfolio.
One more feature of the table is worth naming. At exactly 20% the reserve
can fund all ten deals, so the “not funded” branch never occurs and the two regimes
give identical answers — the clause stops mattering entirely. Complete immunity
from pay-to-play is purchasable, and it costs 20% of the programme. Under the punitive clause
that is worse than the optimum by 0.034 of a turn; under plain dilution it is worse than holding
no reserve at all.
Which changes the instruction
“Build a reserve policy into your programme before the first deal” cannot be
executed as written. The right reserve under one set of documents destroys value under the
other, and the documents are not knowable before the deal. A blanket fifteen per cent applied
to deals with plain pro-rata dilution takes capital out of the fee-advantaged sleeve that the
whole case for co-investment rests on.
What is knowable before the first deal is the question to ask of every
shareholders’ agreement: does this vehicle contain a pay-to-play or punitive
shadow-conversion mechanic, yes or no? Size the reserve from the answer — around
10% where the answer is no, around 15% where it is yes. That is one line of diligence, and on
these figures it is worth about a quarter of a turn of multiple.
And keep the break-even, not the marginal multiple, on the page where the follow-on
decision is recorded. 600 against 250 is the difference between a test the company has to pass
and a test the clause has already passed for it.
The workbook behind this article
Every figure above is a live formula in the companion file for
The Co-Investment Practitioner, which runs the round both ways, prices the clause on a single deal and across the programme, and sizes the reserve as an expectation over the binomial rather than the mean. It is free, and it needs no account and
no email address.
Should corporate debt be fixed or floating?78.1818 per cent of gross debt fixed, and a net floating exposure after cash of -608,000.00 — the proportion, not the instrument.
Does an undrawn revolver count as liquidity?67.4567 per cent of the headroom, and it leaves at a fall in annual revenue of 8.4127 per cent — not the 13.3333 per cent the board deck implies.
Does supply chain finance count as debt?66,049,315 released, and leverage of 2.7622× or 3.1362× depending on which balance the test is asked of — the second is a breach at today's EBITDA.
How do you set a minimum cash balance?Three components, 124,596,281 in total — and the double count that turns a margin of 27,403,719 into an apparent shortfall of -3,988,281.
Is a 2/10 net 60 discount worth taking?An annualised 14.8980 per cent against a revolver at 4.50 per cent — worth 5,471,890 a year, and 0.3132 turns of reported leverage.
At what wealth does a family office pay?A five-person office costs the same $2,442,000 at $100m as at $2bn. Against a tiered multi-family schedule the two curves cross exactly once.
Does the fulcrum move with enterprise value?A worked capital structure at three enterprise values. The break migrates from the first lien to the subordinated notes without a single document changing.
How many companies does a reserve pool defend?Holding pro rata to the Series D costs $14.76m per company. A $40m reserve defends 2.71 of forty — and 61 per cent of the cost is the last round.
How much room a 1.15x downside actually leaves79 basis points of margin. The leverage covenant fails first, five basis points before the coverage covenant the chapter reports on, and 4.6 per cent of EBITDA is the whole cushion.
How the GP catch-up is actually solvedMost write-ups state the catch-up formula then hardcode the answer. Set it as a solve and it moves on its own when the carry rate does.
Six ways to state the same fund's return7.12 per cent, 18.04 per cent, or 1.323 times the public market — one fund, one set of flows. The eleven-point gap is the valuation, and it is not cash.
The IRR at which a closed-ended fund merely tiesA drawdown fund advertising 13.25 per cent ties an evergreen netting 8.64. On committed rather than called capital, 78.7 per cent of the edge vanishes.
The month a remediation trigger has to be armed byMonth 8, on a one-year window and a 14-week hiring lead time. The date is 12W − L/4.33 and holds for any portfolio size — the book only changes the euros.
Two routes to the same NAVFive findings in one quarter-end close, and not one of them was a modelling error. Every one was a control that did not exist.
What a CBAM certificate buffer costs to holdCarry and protection are both linear in the buffer, so the break-even probability is identical at 5 per cent and at 30 — and 2027 costs exactly twice 2026.
What a clawback actually collateralises24 million recovers 13.20 net of tax and 7.20 is escrowed. The rule is e ≥ 1 − t, and every euro won on the tax clause lands uncollateralised.
What a co-investment programme actually saves37 basis points, and a 22.8 per cent total-loss rate erases it. At the usual per-deal cap a single failure is 37 per cent of the annual cohort.
What a diligence exercise actually recoversEighteen basis points is only the part that reaches the yield. Three of the four instruments never do, and the exercise is worth thirty-one.
What a lease mark-to-market is actually worth5,788,000 becomes 807,365 once the over-market stream, the expiry dates and the cost of re-letting are priced — and nothing at all below a 43.7 per cent renewal rate.
What a minimum payment actually does£81.53 leaves the account and £20.46 reaches the debt. On minimums alone the set clears in 258 months and repays 1.78 times what was borrowed.
What a month of delay costs in an enforcement463,000 euros of present value a month. No single error about enforcement, and no pair of errors, moves the indifference point from 58.7 cents to the 72 on the table.
What a pro rata cheque actually costsDefending costs 1.25 times the initial cheque across two rounds, not more in each — and below a 521 exit the follow-on dollars come back worth less than they cost.
What a subscription line does to the IRR20 per cent becomes 38.41 on the same asset while the multiple falls. Two dollars of interest buys 18.4 points, and the longer the line runs the cheaper each point gets.
What one point of fees actually costsOne point on the annual charge turns 738,846 into 567,961 over forty years — 23 per cent of the pot, and 2.43 of wealth lost per 1 of fee.
When the promote stops clearingCarried interest is not proportional to performance near the hurdle. It is a step function, and $2m of headroom is what stands between a promote and none.
Why a secondaries bid-ask gap has no zoneThe seller’s floor and the buyer’s ceiling are one formula at two rates. At equal required returns the zone is exactly zero — here it is 11.02 points apart.
Why refining a due diligence rubric makes it weakerThree of twelve managers carry a terminal flaw and the average approves all three. Splitting eight domains into sixteen makes it easier to hide, not harder.
If this book helped — or didn’t — a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.