The discount to NAV makes the tail look twice as expensive. Measured against what the seller gives up, the gap is small and can reverse.
Compare the two sales on what the seller gives up, not on the discount to NAV. On an illustrative six-fund portfolio, raising $65.15m by selling the three tail funds shows a discount of $24.85m (27.6 per cent), while a 25.1 per cent strip of every fund raising the same cash shows only $10.07m (13.4 per cent). Measured against what the seller expects each interest to be worth if kept, the costs are $7.45m for the tail sale and $6.23m for the strip: a gap of $1.22m, not $14.78m, and one that reverses once the seller values its younger funds more than 10.6 points above the bid.
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 →
An LP that needs liquidity from a secondary sale has two clean choices. It can sell its oldest, smallest positions, the tail, which tidies the portfolio and typically prices at a deep discount. Or it can sell a strip: the same percentage of every fund, so the buyer gets a diversified slice and the seller keeps the same mix of exposure, only smaller. Investment committees usually compare the headline discounts and conclude that the strip is far cheaper. That comparison mixes up two things: how far below NAV a fund trades, and how far below its value to the seller.
| Fund | Vintage | NAV | Bid, % NAV | Hold value, % NAV | Unfunded |
|---|---|---|---|---|---|
| A, buyout | 2019 | 80.0 | 96 | 104 | 10.0 |
| B, buyout | 2018 | 70.0 | 93 | 101 | 5.0 |
| C, growth | 2020 | 60.0 | 88 | 97 | 20.0 |
| D, buyout | 2014 | 35.0 | 78 | 86 | 1.0 |
| E, buyout | 2012 | 30.0 | 72 | 80 | 0.5 |
| F, buyout | 2011 | 25.0 | 65 | 74 | 0.5 |
| Portfolio | 300 | 86.6 | 37.0 |
Hold value is the present value of the distributions the seller expects, net of the capital calls it would still have to fund, at its own required return, divided by NAV. It is the number the seller has to estimate anyway to know whether any bid is acceptable, and the bottom-up NAV is the usual starting point. Here the seller values every fund 8 to 9 points above the bid, so neither option has an unfair advantage built in.
Price = 35.0 × 78% + 30.0 × 72% + 25.0 × 65% = 27.30 + 21.60 + 16.25 = $65.15m
Discount to NAV = 90.0 − 65.15 = $24.85m, or 27.6%
Hold value given up = 30.10 + 24.00 + 18.50 = $72.60m
Economic cost = 72.60 − 65.15 = $7.45m, 11.4% of the cash raised
Strip percentage = cash needed ÷ price of the whole portfolio = 65.15 ÷ 259.85 = 25.07%
NAV sold = 25.07% × 300 = $75.22m; discount to NAV = 75.22 − 65.15 = $10.07m, or 13.4%
Hold value given up = 25.07% × 284.70 = $71.38m
Economic cost = 71.38 − 65.15 = $6.23m, 9.6% of the cash raised
Excel: =Cash/SUMPRODUCT(NAV,Bid) gives 0.2507
| Measure | Tail sale | Strip sale |
|---|---|---|
| NAV sold | 90.0 | 75.2 |
| Discount to NAV | 24.85 | 10.07 |
| Discount, % of NAV sold | 27.6% | 13.4% |
| Hold value given up | 72.60 | 71.38 |
| Economic cost | 7.45 | 6.23 |
| Unfunded commitments transferred | 2.0 | 9.3 |
| NAV kept, number of funds | 210.0, 3 | 224.8, 6 |
The headline discount says the tail sale costs $14.78m more. The economic comparison says $1.22m. Most of the tail's discount is not a transfer to the buyer at all: it reflects NAVs the seller also believes overstate what those funds will pay out. The strip still wins on these inputs, for a mechanical reason: when every fund carries the same gap between bid and hold value, the gap is a larger share of a low price, so each dollar raised from the tail costs more (13.8 cents on fund F against 8.3 on fund A).
The strip sells a quarter of funds A, B and C, which is where a seller that likes its managers sees the most upside. Hold the tail funds as above and widen the gap between hold value and bid on A to C:
| Gap on funds A to C, points | Strip cost | Cents per $ raised | Cheaper option |
|---|---|---|---|
| 4 | 3.97 | 6.1 | Strip |
| 8 | 6.08 | 9.3 | Strip |
| 12 | 8.19 | 12.6 | Tail |
| 16 | 10.29 | 15.8 | Tail |
The break-even is a gap of 10.6 points. A seller that thinks its 2018 to 2020 funds are worth 11 or more points above what buyers bid should sell the tail, even though the reported discount will look twice as bad. And if the seller privately agrees with the buyer about the tail, with hold value equal to bid, the tail sale costs nothing at all in economic terms, whatever the discount to NAV says.
Choosing on the percentage discount to NAV. It compares a price with an accounting mark, and the marks in a tail portfolio are the least reliable in the book: tail-end interests trade deeper partly because their NAVs are stale and their remaining value is concentrated in a few assets. The decision should rest on hold value given up per dollar raised. The second mistake is to ignore what else moves: the strip transfers $9.3m of unfunded commitments, which frees future liquidity even though their value is already netted in the hold values, while the tail sale removes three fund relationships and their reporting and administration with them.
Price both options against the seller's own value of each interest. Here a strip raises $65.15m for $6.23m of value given up and a tail sale for $7.45m, a much closer call than 13.4 against 27.6 per cent suggests, and the answer flips once the seller rates its younger funds 10.6 points above the bid. The free workbook for this case builds the bottom-up NAV and the buyer's model that sit behind each fund's bid.
A sale of the same percentage of every fund interest in a portfolio, so the buyer receives a diversified slice and the seller keeps its mix of managers and vintages, only smaller. In the illustrative case a 25.07 per cent strip of a $300m NAV portfolio raises $65.15m at a blended 86.6 per cent of NAV.
Their NAVs are often stale, their remaining value sits in a handful of assets, and buyers face fixed diligence costs on small positions. Part of the discount reflects marks the seller does not believe either: in the example, funds bid at 65 to 78 per cent of NAV are held by the seller at 74 to 86 per cent, so the true cost is $7.45m, not the $24.85m discount.
Yes, pro rata. Selling 25.07 per cent of every fund transfers the same share of each unfunded commitment, $9.3m of $37.0m in the example, against only $2.0m for the tail sale. Their value is already netted in the hold values, but the relief on future capital calls is a liquidity benefit of the strip that the value comparison leaves out.
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.
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