Acquisition debt on an LP interest is repaid from the first distributions, so it is outstanding for less than two years and adds far less return than the multiple suggests.
Leverage on a secondary purchase is repaid from the fund's first distributions, so it adds much less return than the same debt on a buyout. On an illustrative LP interest bought at 88 for a NAV of 100 and returning 130 over four years, a 40 per cent facility at 8 per cent lifts the IRR from 16.1 to 18.5 per cent, because the cash sweep clears it in year 2. If the distributions slip a year and shrink, the same facility cuts the IRR from 4.7 to 3.3 per cent.
Worked in full in The Private Equity Secondaries Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Secondary buyers borrow against the interests they buy, either deal by deal or through a fund-level facility. The pitch is simple: a mid-teens asset financed at high single digits should produce a twenty per cent return. The arithmetic does not cooperate, for one structural reason. A secondary interest is a self-liquidating asset that distributes from the first year, and lenders take those distributions first.
| Input | Value |
|---|---|
| Reported NAV | 100.0 |
| Price (88% of NAV, a 12% discount) | 88.0 |
| Base distributions, years 1 to 4 | 20, 35, 40, 35 |
| Total distributions, base | 130.0 |
| Facility (40% of price) | 35.2 |
| Equity | 52.8 |
| Interest rate, paid annually | 8% |
| Repayment | 100% cash sweep |
No unfunded commitment, so the only cash flows are the price and the distributions. Fees on the facility are ignored; they make the conclusion stronger, not weaker.
Each year: interest = opening balance × 8%; distribution pays interest, then principal; equity receives what is left.
Levered IRR = IRR(−equity, distribution − debt service in each year)
In Excel, with distributions in C5:F5 and the opening balance in C7: interest =C7*$B$3, debt service =MIN(C5,C7+C8), to equity =C5-C9, then =IRR(B10:F10) on the equity row.
Unlevered, the buyer pays 88.0 and receives 130.0: a 1.48x multiple and an IRR of 16.1 per cent. Levered, it pays 52.8 of equity and the facility runs as follows.
| Year | Distribution | Interest | Principal | Closing debt | To equity |
|---|---|---|---|---|---|
| 1 | 20.0 | 2.82 | 17.18 | 18.02 | 0.00 |
| 2 | 35.0 | 1.44 | 18.02 | 0.00 | 15.54 |
| 3 | 40.0 | 0.00 | 0.00 | 0.00 | 40.00 |
| 4 | 35.0 | 0.00 | 0.00 | 0.00 | 35.00 |
| Total | 130.0 | 4.26 | 35.2 | 90.54 |
The equity of 52.8 receives 90.54: a multiple of 1.71x and an IRR of 18.5 per cent, 2.4 points above the unlevered 16.1. The multiple moves a lot because the denominator shrinks; the IRR moves little because the debt is gone before year 3. Interest of 4.26 has come out of the same distributions, so profit in money falls from 42.0 to 37.7.
That is the shape to expect on any secondary that distributes early. Leverage is only working while it is outstanding, and the sweep is designed to make that as short as possible. A buyout lender is repaid at exit; a secondary lender is repaid by the asset itself, from the first cheque.
The stress case delays every distribution by a year and cuts the total from 130.0 to 104.0, with cash of 16, 28, 32 and 28 arriving in years 2 to 5. Unlevered, the interest returns 1.18x and 4.7 per cent: disappointing, but positive. Levered, nothing reaches equity until year 3. Interest of 2.82 is capitalised in year 1, the balance peaks at 38.02, and total interest rises to 7.86. The levered IRR falls to 3.3 per cent, below the unlevered result, because the asset now earns less than the 8 per cent the debt costs.
| Leverage (% of price) | Base IRR | Base multiple | Stress IRR | Stress multiple |
|---|---|---|---|---|
| 0% | 16.1% | 1.48x | 4.7% | 1.18x |
| 20% | 16.8% | 1.58x | 4.2% | 1.18x |
| 40% | 18.5% | 1.71x | 3.3% | 1.15x |
| 50% | 19.7% | 1.82x | 2.4% | 1.11x |
Going from nothing to 50 per cent leverage buys 3.6 points in the base case and costs 2.3 in the stress. The interest rate matters less than people expect: at 40 per cent leverage, moving the facility from 6 to 12 per cent takes the base IRR only from 19.1 to 17.4 per cent, again because the debt does not stay long enough for the rate to compound.
The trade-off is close to the one a deferred purchase price offers, with one difference. A deferral is repaid on a date; a facility is repaid from distributions and accrues interest when they are late. How a seller-financed deferral compares is worked in how much a deferred payment is worth in a secondary deal.
The common mistake is modelling secondary leverage with a bullet repayment at the end of the hold, as on a property or a buyout. That keeps 35.2 of debt working for four years and produces a levered IRR in the twenties. No secondary lender will lend on those terms against an LP interest, because the collateral is the stream of distributions it would be leaving with the buyer. Model the sweep the facility agreement actually contains, including any cash that must be retained for the interest's own capital calls.
The second mistake is reporting only the multiple. A 1.71x equity multiple beside a 1.48x unlevered one reads as 0.24x of extra value. It is not: the money profit fell, and the IRR gained 2.4 points. Investors who look at DPI and at profit in money should see the unlevered figures next to the levered ones.
On a secondary, leverage is repaid by the asset's own early cash, so it adds a little IRR in the base case and subtracts it in the stress: 16.1 to 18.5 per cent on the way up, 4.7 to 3.3 per cent on the way down at 40 per cent debt. The decision rests on the timing of distributions, not on the spread between the asset return and the rate. The free workbook for this case projects distributions year by year and stresses delay and value together, which is exactly the input the facility depends on.
Because the debt does not stay outstanding. A secondary interest distributes from year one and a cash sweep sends those distributions to the lender first. On a 35.2 facility against an 88 price, the sweep clears the loan in year 2, so the 40 per cent leverage works for under two years and adds 2.4 points of IRR, from 16.1 to 18.5 per cent.
It increases the multiple on equity and reduces the profit in money. With 40 per cent debt at 8 per cent, the equity multiple rises from 1.48x to 1.71x because less equity is invested, but interest of 4.26 comes out of the same distributions, so profit falls from 42.0 to 37.7. Investors paid on profit and IRR see different stories.
When distributions slip or the fund returns less than the cost of debt. Delay the same interest by a year and cut its total to 104: unlevered IRR falls to 4.7 per cent, below the 8 per cent facility rate, and the levered IRR falls further to 3.3 per cent. At 50 per cent leverage it is 2.4 per cent.
Deferral and leverage are compared in a companion case that extends chapters 8 and 9 of The Private Equity Secondaries Investor. 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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