The buyer of an LP interest also buys the obligation to fund future calls at par, and that obligation has a present value of its own.
Price an LP interest as two legs: the present value of the distributions from the existing NAV, plus the present value of the unfunded commitment's calls and returns, both at the buyer's target return. On an illustrative interest with a NAV of 100 and a 15 per cent target, adding 40 of unfunded expected to return 1.45x cuts the bid from 90.6 to 88.6 per cent of NAV. The unfunded is only neutral if it earns 1.54x.
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 prices are quoted as a percentage of NAV, which makes the unfunded commitment easy to forget. The buyer does not get it for free and does not get it at a discount. It inherits the obligation to send cash at par whenever the GP calls, into investments that have not been made yet. If those investments are expected to earn less than the buyer's target, the obligation has a negative value and the price for the NAV must fall to pay for it.
| Input | Value |
|---|---|
| Reported NAV at the reference date | 100 |
| Expected distributions from that NAV, years 1 to 4 | 20, 35, 45, 30 |
| Multiple on the existing NAV | 1.30x |
| Unfunded commitment | 40 |
| Unfunded called, years 1 and 2 | 20, 20 |
| Expected multiple on the unfunded, returned 40/60 in years 4 and 5 | 1.45x |
| Buyer's target IRR | 15% |
PV of NAV leg = 20 ÷ 1.15 + 35 ÷ 1.152 + 45 ÷ 1.153 + 30 ÷ 1.154 = 90.60
With no unfunded, a 15 per cent buyer could pay 90.6 per cent of NAV, a 9.4 per cent discount. In Excel, with the flows in B3:B6 for years 1 to 4: =NPV(15%,B3:B6).
The unfunded leg is a small fund of its own: 20 out in year 1, 20 out in year 2, then 58 back, 23.2 in year 4 and 34.8 in year 5.
PV of unfunded leg = −20 ÷ 1.15 − 20 ÷ 1.152 + 23.2 ÷ 1.154 + 34.8 ÷ 1.155 = −1.95
Its own IRR is 12.7 per cent, below the 15 per cent target, so it destroys value at the buyer's hurdle: about 0.049 for every unit of unfunded.
Price = 90.60 − 1.95 = 88.65, or 88.6 per cent of NAV, an 11.4 per cent discount.
Check: −88.65 at time zero, then all the combined flows, gives an IRR of 15.0 per cent.
The unfunded widened the discount by 1.9 points. Yet on a total-exposure basis, price plus unfunded against NAV plus unfunded, the buyer pays 128.65 for 140, a discount of only 8.1 per cent. Both numbers are correct. The first is what goes in the bid letter; the second shows how far below par the buyer's whole outlay, NAV and future calls together, is bought.
| Unfunded | Price, % of NAV | Discount to NAV | Discount to NAV plus unfunded |
|---|---|---|---|
| 0 | 90.6 | 9.4% | 9.4% |
| 20 | 89.6 | 10.4% | 8.6% |
| 40 | 88.6 | 11.4% | 8.1% |
| 60 | 87.7 | 12.3% | 7.7% |
| 80 | 86.7 | 13.3% | 7.4% |
The two discount columns move in opposite directions. As the unfunded grows, the headline discount widens, which looks like a better deal, while the discount on everything the buyer is committing to narrows. Yet every row earns exactly the 15 per cent target: the wider headline discount is not a bargain, only the payment for funding a larger below-target unfunded at par. Neither discount on its own says which interest is cheaper; the IRR at the price does.
| Multiple on unfunded | PV of unfunded | Price, % of NAV | Discount |
|---|---|---|---|
| 1.20x | −7.22 | 83.4 | 16.6% |
| 1.45x | −1.95 | 88.6 | 11.4% |
| 1.70x | 3.32 | 93.9 | 6.1% |
| 2.00x | 9.65 | 100.2 | −0.2% |
Here is the reason buyers pay par or a premium for young funds from strong managers. If the undrawn capital is expected to earn 2.00x, the unfunded is worth 9.65 at a 15 per cent target, enough to pay 100.2 for the NAV. The break-even is 1.54x: above it the unfunded adds to the price, below it it subtracts.
Blind pool risk. The NAV leg can be diligenced company by company. The unfunded leg cannot: it is a forecast of deals not yet made, and its multiple is the least knowable input in the model. That is why the 1.54x break-even is worth stating in the investment memo, next to the manager's record on comparable deployment.
The common mistake is to price the NAV and then treat the unfunded as a neutral add-on. A buyer who pays 90.6 because that is what the NAV is worth at 15 per cent, then funds 40 of calls at a 12.7 per cent return, ends up with 14.3 per cent overall. The miss is small here because the unfunded is not far below target, but it scales with both the unfunded and the gap: at 1.20x on the unfunded the right price is 83.4, and paying the NAV-only price would be a much larger error. The opposite mistake is to compare headline discounts across interests with very different unfunded balances, as if 11.4 per cent on one were cheaper than 9.4 per cent on another.
Split every LP interest into its NAV leg and its unfunded leg, price each at the target, and add them. Then state the multiple the unfunded must earn to be worth zero, here 1.54x. The deal model in the free workbooks for this book projects distributions and remaining calls for an interest over time. For the separate adjustment between the reference date and closing, see how a secondary price is adjusted after the reference date.
No. The price is quoted as a percentage of NAV, and the buyer separately assumes the unfunded commitment, which it will fund at par as the GP calls it. In the worked case the buyer pays 88.6 for a NAV of 100 and takes on 40 of future calls, a total exposure of 128.65 for 140 of NAV plus unfunded.
Because the discount applies only to the NAV, while the unfunded is funded at par. If the undrawn capital is expected to earn less than the target, the NAV discount must also pay for that shortfall. In the worked case a buyer paying the NAV-only price of 90.6 would earn 14.3 per cent, not 15. The required 11.4 per cent discount to NAV is only an 8.1 per cent discount on NAV plus unfunded.
The multiple whose IRR equals the buyer's target, given the timing of the calls and returns. With calls in years 1 and 2 and returns in years 4 and 5, that is 1.54x at a 15 per cent target. At 1.45x the unfunded is worth minus 1.95 per 100 of NAV, at 2.00x plus 9.65.
This article is one calculation from 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.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: private equity and private markets → · All 453 articles →
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.