A secondary discount is a cost of capital in disguise: once it is annualised over the hold, the choice against a NAV loan turns on one break-even discount.
A secondary sale and a NAV loan both turn unrealised value into cash, and the cheaper one is found by annualising the secondary discount into the return the buyer earns and comparing it with the loan's all-in rate. On an illustrative fund raising $150M over three years, a sale at a 12 per cent discount costs 13.74 per cent a year against a NAV loan at 10.56 per cent, and the loan leaves the fund $18.1M better off. The break-even discount is 4.2 per cent.
Worked in full in The Fund Finance Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A general partner who wants to return cash to investors before the portfolio is ready to exit has two ways to do it. It can sell a slice of the portfolio to a secondary buyer, at a discount to NAV, or borrow against the portfolio with a NAV facility and repay from exits. The discount looks like a one-off loss and the loan like a running cost, so they are often compared on the wrong basis. Put both on the same axis, value left for investors at the end of the hold, and the choice reduces to one formula.
| Input | Value |
|---|---|
| Portfolio NAV | 1,000 |
| Cash to be raised for distribution | 150 |
| Secondary discount to NAV | 12% |
| NAV loan: SOFR 4.00% + 600 bp, interest accruing | 10.00% |
| Upfront fee on the loan | 1.5% |
| Expected growth of the remaining assets, a year | 9% |
| Years until exits repay the loan | 3 |
Secondary: value left = (NAV − need ÷ (1 − discount)) × (1 + g)T
Loan: value left = NAV × (1 + g)T − gross loan × (1 + r)T
Break-even discount = 1 − ((1 + g) ÷ (1 + all-in rate))T
In Excel: =1-((1+g)/(1+AllIn))^T, and the cost of the sale as a rate =(1+g)/(1-Disc)^(1/T)-1.
The secondary. To raise 150 at a 12 per cent discount the fund sells 150 ÷ 0.88 = 170.5 of NAV, giving up 20.5 of value on day one. The remaining 829.5 grows at 9 per cent for three years to 1,074.3.
The loan. To net 150 after a 1.5 per cent fee the fund borrows 152.3. The whole portfolio grows to 1,295.0; the loan, accruing at 10.00 per cent, has become 202.7. What is left is 1,092.3. The fee and the accrual together make an all-in rate of 10.56 per cent.
The comparison. 1,092.3 against 1,074.3: the loan leaves $18.1M more, 1.81 per cent of today's NAV. The investors receive the same 150 today in both cases. The same $150M on a $1,000M portfolio is compared with preferred equity elsewhere; the secondary is the third route.
The same answer as a rate. A buyer who pays 88 for assets that grow 9 per cent a year and are realised in three years earns 13.74 per cent a year. That is the fund's cost of the secondary, and it is 3.18 points above the loan.
| Asset growth a year | Break-even discount |
|---|---|
| 0% | 26.0% |
| 5% | 14.3% |
| 9% | 4.2% |
| 12% | −4.0% |
The break-even discount depends almost entirely on how the assets are expected to perform against the loan rate. If they grow faster than the loan costs, the loan wins at any discount, even a premium. If they grow slowly, a secondary discount of up to 14.3 per cent is the cheaper money, because the fund sheds assets that would have earned less than the loan charges.
| Asset growth | Discount 5% | Discount 12% | Discount 20% |
|---|---|---|---|
| 0% | −44.8 | −32.2 | −15.2 |
| 5% | −19.9 | −5.4 | 14.4 |
| 9% | 1.8 | 18.1 | 40.1 |
| 12% | 19.1 | 36.8 | 60.7 |
The hold matters too. The secondary's cost is a one-off discount spread over the years until exit: at 12 per cent, it is 23.86 per cent a year over one year, 13.74 over three and 11.82 over five, the same effect that makes one secondary discount give very different IRRs. A loan repaid quickly is cheap relative to a discount; one that runs long loses part of that edge.
The common mistake is to compare the discount with one year of interest: 12 points against 10.56, so the sale looks only slightly dearer. That ignores that the discount is paid once and the interest every year, and that the assets sold would have kept growing. The opposite mistake is to treat the growth assumption as a fact. The loan wins here because the fund expects its assets to earn 9 per cent, and that is precisely the assumption a secondary buyer is pricing at a discount. The loan also adds leverage the sale does not: LTV starts at 15.2 per cent and reaches 20.3 per cent after a 25 per cent fall in NAV, and the covenant tests adjusted NAV, not the reported figure. Finally, both routes raise DPI by the same 150; what a NAV loan distribution does to TVPI is the cost side of the same calculation.
Annualise the secondary discount over the expected hold and set it against the loan's all-in rate, or compute the break-even discount directly. On these illustrative figures the sale costs 13.74 per cent a year against 10.56, and the loan is cheaper unless the discount falls below 4.2 per cent or the assets grow at well under 9 per cent. The free workbook for this case takes the NAV facility side further, from reported NAV to the loan-to-value that breaches.
The discount at which selling assets costs the same as borrowing against them: one minus ((1 + asset growth) divided by (1 + loan rate)) to the power of the years outstanding. With a 10.56 per cent all-in loan over three years, it is 4.2 per cent at 9 per cent growth, 14.3 per cent at 5 per cent and 26.0 per cent with no growth.
Because the discount is paid once and spread over fewer years. Selling at 12 per cent below NAV with assets growing 9 per cent gives the buyer 23.86 per cent a year if the assets are realised in one year, 13.74 per cent over three and 11.82 per cent over five. A NAV loan's cost does not depend on the hold in the same way.
When the remaining assets are expected to grow slowly, or the discount is small. At 5 per cent growth a sale at a 5 per cent discount leaves the fund $19.9M better off than a $150M NAV loan at 10.56 per cent over three years. The loan also adds leverage: a 25 per cent fall in NAV lifts its LTV from 15.2 to 20.3 per cent.
This article is one calculation from The Fund Finance Professional. 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 1340 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.