Far less than most sponsors expect, and the amount depends entirely on which dilution formula the agreement uses. A sponsor holding 10 per cent that fails to fund its 2 of a 20 call falls to 7.04 per cent under a credit multiple at 1.5 times, but to 2.99 per cent under a capital account reduction at the same 1.5 times. Both are written as “dilution at 1.5 times”. In each case the promote survives intact.
Two formulas, both called 1.5 times
Take a venture in which the investor holds 90 per cent and the sponsor 10 per cent. Contributions to date are 45 from the investor and 5 from the sponsor, a total of 50, all figures in millions. A call of 20 is issued: 18 to the investor and 2 to the sponsor. The sponsor cannot fund its 2. The investor funds its own 18 and the sponsor's 2, and elects dilution.
Under straight dilution, percentages are simply recalculated on contributed capital. The investor has now contributed 65 and the sponsor 5, out of 70. The sponsor has been diluted, but only by the arithmetic of the money.
Under a credit multiple formula, the non-defaulting partner is credited with a multiple of the amount it funded on the defaulter's behalf. At 1.5 times, the investor is credited with 45 plus 18 plus 3, or 66, against the sponsor's 5, out of a total of 71.
Under a capital account reduction formula, the defaulting partner's contributed capital is reduced by a multiple of the unfunded amount. At 1.5 times, the sponsor's account falls from 5 to 2 and the investor's is 65, out of a total of 67. At 2 times, the sponsor's account falls to 1, out of a total of 66.
The same default, four dilution formulas. Contributions in $ millions.
Formula
Sponsor's stake after
Investor's stake after
Before the call (contributed 5 / 45)
10.00%
90.00%
Straight dilution on contributed capital
7.14%
92.86%
Non-defaulter credited at 1.5x the shortfall
7.04%
92.96%
Defaulter's capital account reduced by 1.5x
2.99%
97.01%
Defaulter's capital account reduced by 2.0x
1.52%
98.48%
Investors frequently negotiate the credit multiple believing it is punitive. It is not. Crediting an extra 1 of notional capital against a base of 70 moves the sponsor by a tenth of a percentage point — from 7.14 per cent under plain arithmetic to 7.04 per cent. The capital account reduction is the remedy with teeth, and it is the one investors usually mean.
What the dilution is actually worth
Percentages are not money. Run the same default through an exit and the remedy looks smaller still, because it never reaches the part of the sponsor's economics that matters.
Assume an exit generating 30 million of residual profit above the preferred return and returned capital, with a 20 per cent promote. The promote is 6 million either way. What changes is the sponsor's share of the remaining 24 million.
Sponsor's proceeds from the same exit, in $ millions, after the same missed 2 million call.
Measure
Credited at 1.5x
Capital account cut 1.5x
Sponsor's interest after the default
7.04%
2.99%
Share of the 24 million residual
1.69
0.72
Promote at 20 per cent of 30 million
6
6
The dilution costs the sponsor under a million. The promote is worth six times that. An investor that dilutes without touching the promote has barely moved the sponsor's economics, which is why sponsors negotiate for dilution-based remedies and investors negotiate for promote-based ones.
The remedies that are not dilution
Dilution is one item on a menu, and the election among them is itself worth more than any fixed consequence. The default loan is the compensatory one: the investor advances the missing 2, it bears interest at 15 per cent compounding annually, and nothing is distributed to any partner — not the preferred return, not a return of capital — until it is repaid. Two years later the obligation is 2 times 1.15 squared, or 2.645. Its weakness is that a punitive rate with priority repayment is worth nothing if the venture never distributes.
Forced buyout at a discount looks harsher than dilution and is often harsher than it reads. A price of seventy to eighty per cent of fair value, payable at exit rather than on completion, compounds the discount with time: a 75 per cent price on a 6 million interest is 4.5 million paid three years later with no interest, which at a 10 per cent discount rate is worth about 3.38 million, or 56 per cent of fair value.
Suspension of major decision rights is the mildest remedy and among the most effective, because consent rights exist to protect capital at risk and a partner declining to put capital at risk has weakened its claim to the protection. Promote reduction or forfeiture is the only remedy that materially changes a sponsor's economics; the proportionate reduction is the defensible landing point.
What to do with this before signing
The remedies are the one part of the agreement where both parties should imagine themselves on the wrong side of it. Three things follow.
Write the formula out in full in the term sheet. “Dilution at 1.5 times” describes two remedies that differ by more than four percentage points of ownership on the same facts.
Define the base in the same clause as the formula. Contributed capital and committed capital coincided at 10 per cent here only because funding had been pro rata; where it has not been, the wrong base produces a result neither party intended.
Run a realistic missed call through the exact draft and price the outcome, promote included. A remedy that survives is worth more than a remedy that impresses.
An agreement containing only dilution has given the investor a remedy that does not reach the sponsor's money. An agreement containing only promote forfeiture has given the sponsor a remedy that does not exist against the investor at all.
The workbooks behind this article
Every figure above is a live formula in the free companion files for
Real Estate Joint Ventures. Each workbook ends with a Checks sheet
setting the printed figure beside the computed one. No account and no email address.
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