The GP sits on both sides of the price, and its economics in the two funds are not symmetrical. That is what a cross trade review has to measure.
When a GP sells a company from an older fund that is in carry to a newer fund it also manages, every dollar above fair value pays it 20 cents of carry now and more management fees later, against a carry loss in the buying fund that may never arrive. On an illustrative 200.0 company crossed at a 10 per cent premium, the GP gains 4.0 of carry and 1.2 of fees and expects to lose 2.4: a net gain of 2.8, while the buying fund's LPs expect to lose 18.8. That asymmetry is what an ODD review of a cross trade has to test.
Worked in full in Operational Due Diligence in Private Equity by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A cross trade, or fund-to-fund transfer, moves an asset between two vehicles with the same manager. It can be the right answer: the older fund is near the end of its term, the newer fund wants more of a business it knows. But the GP sits on both sides of the price, and its economics in the two funds are not symmetrical. The review is not about whether the trade is permitted. It is about whether the price was set by someone without that asymmetry.
| Input | Value |
|---|---|
| Independent fair value of the company | 200.0 |
| Cross trade price, 10% premium | 220.0 |
| Carried interest in both funds | 20% |
| Selling fund (Fund II) | past its hurdle, catch-up complete |
| Buying fund (Fund IV) fee after its investment period | 1.5% of invested cost |
| Years the asset is held on that fee basis | 4 |
| Probability Fund IV ends in carry | 60% |
Fund II carry gained = 20% × excess price = 0.20 × 20.0 = 4.0, received at closing.
Fund IV fees gained = excess × 1.5% × 4 years = 1.2, because the fee is charged on a cost basis that is 20.0 too high.
Fund IV carry lost = 20% × excess × probability = 0.20 × 20.0 × 60% = 2.4, years later and only if Fund IV clears its hurdle.
Net expected gain = 4.0 + 1.2 − 2.4 = 2.8, or 0.28 for every 1 per cent of premium.
The structure is the point. The gain is certain and immediate; the loss is contingent and deferred. Discount the expected 2.4 over five years at 8 per cent and it is worth 1.63, and the net gain is 3.6 before discounting the fees, which arrive over the four years rather than at closing.
Solve for the probability of Fund IV carry at which the GP would be indifferent: (4.0 + 1.2) ÷ 4.0 = 130%. No probability is that high. Even if Fund IV is certain to pay carry, the GP still gains 1.2 from fees; if Fund IV never reaches its hurdle, it gains 5.2. On these terms the GP is better off at any premium, which is why the price cannot be left to its judgement, however honest.
The incentive reverses when the selling fund is below its hurdle. With no carry to gain in Fund II, the GP nets 1.2 of fees against 2.4 of expected carry lost: −1.2. A GP selling out of an underwater fund is pulled the other way, towards a low price that flatters the newer fund. The ODD question is the same in both cases: which side of the GP's book benefits from the price?
| Party | Effect |
|---|---|
| Fund II LPs: 80% of the excess | +16.0 |
| GP: Fund II carry | +4.0 |
| GP: Fund IV fees | +1.2 |
| GP: expected Fund IV carry | −2.4 |
| Fund IV LPs: expected loss incl. fees | −18.8 |
If Fund IV does end in carry, its LPs bear 80 per cent of the overpayment plus the fees: 17.2. An LP with equal shares of both funds is partly hedged, but most Fund IV investors were never in Fund II. The GP's own commitment barely moves the incentive: at 2 per cent of each fund it gains 0.3 on the selling side and loses 0.4 on the buying side, against 2.8 of fee and carry gain.
| Premium | Price | Fund II carry | Fund IV fees | Fund IV carry lost | GP net | Fund IV LPs lose |
|---|---|---|---|---|---|---|
| −5% | 190.0 | −2.0 | −0.6 | −1.2 | −1.4 | −9.4 |
| 0% | 200.0 | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
| 5% | 210.0 | 2.0 | 0.6 | 1.2 | 1.4 | 9.4 |
| 10% | 220.0 | 4.0 | 1.2 | 2.4 | 2.8 | 18.8 |
| 15% | 230.0 | 6.0 | 1.8 | 3.6 | 4.2 | 28.2 |
The relationship is linear: each point of premium moves 0.28 to the GP and 1.88 away from the buying fund's LPs. A valuation range of plus or minus 5 per cent, normal for a private company, is worth 1.4 to the GP either way.
Assuming the buying fund's carry offsets the selling fund's carry, so the GP is neutral. It is not: the fee on the higher cost basis is certain, and the buying fund's carry is not. Here that makes 2.8 of expected gain out of a premium that looked like a wash. The related case of a GP-led continuation vehicle is in how much carry a GP crystallises in a continuation vehicle.
Write out the GP's three cash flows at the proposed price and check who set it. On a 10 per cent premium the GP nets 2.8 and the buying fund's LPs lose 18.8. Operational Due Diligence in Private Equity treats conflicts as something to measure, not list, and the free workbook and working documents give a blank model for your own review programme.
A sale of a portfolio company or interest from one fund to another fund managed by the same GP. It needs disclosure and usually LPAC consent in both funds because the GP sets terms on both sides. In the illustrative case a 10 per cent premium on a 200.0 company moves 20.0 of value between the two funds' investors.
Because its gains and losses are asymmetric. With the selling fund in carry, a 20.0 premium pays 4.0 of carry at once and 1.2 of fees from the buying fund, while the carry lost in the buying fund, 2.4 at a 60 per cent probability, is later and uncertain. The net expected gain is 2.8.
Ask who set the price and against what: a third-party bid or market test is strongest, an independent valuation next, the GP's own mark weakest. Ask where each fund stands against its hurdle, since that sets the sign of the GP's incentive. Each point of premium here moves 0.28 to the GP and 1.88 from the buying fund's LPs.
This article is one calculation from Operational Due Diligence in Private Equity. 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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