Case 064Investment evaluation and pitchesHard
You hold an LP stake in Dhruvtara Opportunities Fund with Rs 36 crore of NAV and Rs 20 crore still to be called. A secondary buyer targeting 15% makes an offer. What price would you accept?
1The situation
Your family office committed Rs 50 crore to Dhruvtara Opportunities Fund, a private equity fund. Rs 30 crore has been called and invested; the fund reports your share of net asset value at Rs 36 crore. Rs 20 crore is unfunded and will be called in two instalments of Rs 10 crore over the next two years. The fund has five years left and will distribute everything at the end.
You expect the portfolio to earn 18% a year gross. The management fee is 2% of commitment, Rs 1 crore a year, drawn from you in addition to the calls. Carried interest is 20% of profit over total paid-in capital, payable only if the fund beats an 8% hurdle, with full catch-up. A secondary buyer wants a 15% return.
2Your task
What price should the buyer offer, what is the stake worth to you if you keep it, and what price would you accept?
Quick check
Before working it: should the buyer pay more or less than the Rs 36 crore NAV?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
A buyer targeting 15% should pay about Rs 33 crore, 9% below NAV; the stake is worth about Rs 39 crore to you at a 12% required return, so do not sell much below the low thirties unless you need the cash. On 18% gross the stake pays out about Rs 106 crore in year 5 after Rs 13 crore of carry. Against that the buyer funds Rs 20 crore of calls and Rs 5 crore of fees. Every 3 points of gross return moves the price by roughly Rs 5 crore.
Step 1Why is the NAV not the price?
Because the NAV is what the fund has already invested on your behalf, not what the stake will pay. A buyer takes on three things: the Rs 36 crore of assets, an obligation to fund Rs 20 crore of calls and Rs 5 crore of fees, and a wait of five years for the money. It is like buying a half-built flat from someone who has paid Rs 36 lakh of a Rs 61 lakh contract: you would not pay them Rs 36 lakh, because you still owe the builder Rs 25 lakh and cannot live in it for years. The unfunded commitmentThe part of a fund commitment that has not yet been called; the buyer of a stake must pay it when the fund asks. is the part sellers forget to subtract.
Step 2What does the stake pay out?
Grow each rupee at 18% to year 5. The Rs 36 crore of NAV becomes Rs 82.4 crore. The Rs 10 crore called in year 1 compounds for four years to Rs 19.4 crore and the year 2 call for three years to Rs 16.4 crore. Gross value at year 5 is Rs 118.2 crore against total paid-in of Rs 55 crore (Rs 50 crore of capital plus Rs 5 crore of fees), so profit is Rs 63.2 crore and carry at 20% is Rs 12.6 crore. The hurdle is comfortably beaten, so with full catch-up the manager takes the full 20%. Net distribution: Rs 105.5 crore.
| Year | Calls | Fee | Distribution | Buyer's cash flow |
|---|---|---|---|---|
| 0 | (32.9) price | |||
| 1 | (10) | (1.0) | -11.0 | |
| 2 | (10) | (1.0) | -11.0 | |
| 3 | (1.0) | -1.0 | ||
| 4 | (1.0) | -1.0 | ||
| 5 | (1.0) | 105.5 | 104.5 |
Step 3What is the stake worth to you if you keep it?
The same flows at your own required return. At 12%, the stake is worth about Rs 39.4 crore to you, above NAV; the buyer's Rs 32.9 crore is simply the same cash discounted harder. The gap of about Rs 7 crore is the price of liquidity and of the buyer's scepticism. If you paid the Rs 36 crore NAV for these flows your return would be about 13.5%, which is what an 18% gross return becomes after fees and carry on a fund that is only 60% drawn.
Step 4So what price do you accept?
Name a floor and say what moves it. Around Rs 33 crore is a fair offer from a buyer at 15%; near NAV would be generous to you; below Rs 30 crore the buyer is earning 16% on your optimism and you should hold. Then test the one number that matters: if the portfolio earns 12% rather than 18%, the buyer's price falls to Rs 22.9 crore, and if you privately doubt the 18%, a bid in the low thirties starts to look sensible. Say the limits: real carry waterfalls are deal-by-deal or whole-fund with clawbacks, the calls may arrive faster or slower, and a buyer will haircut the NAV itself if the marks look stale. Check the fund agreement before quoting a figure.
Where candidates lose it
The usual miss is pricing the NAV alone: growing Rs 36 crore at 18% and discounting at 15% gives a number above NAV, and the candidate tells the buyer to pay a premium. The Rs 20 crore of calls and Rs 5 crore of fees are the buyer's problem now, and they come off the price.
The second is forgetting carry. Twenty percent of the profit goes to the manager before anything reaches the LP, which takes about Rs 13 crore off the final distribution.
What the interviewer asks next
- The buyer also wants the seller to keep funding the Rs 20 crore of calls. How does the price change?
- How would a deal-by-deal carry waterfall change the net distribution?
- Why might a secondary buyer pay above NAV for a fund in its final year?
Asked at Baupost Group, Equity Hedge, Boston, 2018 (Wall Street Oasis): He wanted me to evaluate my potential stake as an LP in a hedge fund. How much would I be willing to pay?
Asked at Baupost Group, Equity Hedge, Boston, 2018 (Wall Street Oasis): Asked me to evaluate my LP stake in a fund.
Company names and figures are illustrative.