Case 098Alternatives and private marketsHard

A client is offered a limited partner stake in a private fund at 80% of NAV: NAV Rs 4 crore, Rs 1 crore still uncalled. If NAV grows 12% a year for 4 years and the uncalled amount is drawn in year 1, what is his return?

The situation

Jaideep Contractor is offered a secondary purchase of an existing investor's stake in a private equity fund. The stake's latest reported net asset value is Rs 4 crore, and the seller wants Rs 3.2 crore, 80% of NAV. The buyer also takes on the seller's remaining commitment: Rs 1 crore not yet called, which the fund expects to call at the end of year 1.

Assume the fund's NAV, including the called money, grows 12% a year and that the stake is fully realised at NAV at the end of year 4. The reported NAV is six months old and set by the fund manager.

Your task

What IRR and money multiple does he earn, how much of it comes from the discount, and what could make the discount an illusion?

Quick check

If the stated NAV turns out to be 20% too high, what is Jaideep's IRR?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

About 17.4% a year and 1.83 times his money, against 12% for a buyer at NAV. He pays Rs 3.2 crore and a Rs 1 crore call and receives about Rs 7.70 crore in year four. The Rs 80 lakh discount adds about 5.4 points of IRR, but only if the Rs 4 crore NAV is real; if it is 20% overstated, his return falls to the fund's own 12%.

Step 1What exactly is he buying?

A share of a fund's existing portfolio, valued by its manager, plus a promise to pay more later. Buying a half-built flat from someone who wants out gets you a discount, and the remaining instalments to the builder. Jaideep pays Rs 3.2 crore for Rs 4 crore of reported NAV and takes on a Rs 1 crore uncalled commitmentMoney a fund investor has promised but the fund has not yet asked for; the investor must pay it when the fund calls it. that he must meet in year one. The capital call is not optional, so he needs Rs 1 crore of liquidity set aside on day one.

Step 2What return does he earn?

Lay out the cash flows and solve. NAV of Rs 4 crore grows to Rs 4.48 crore in year one, the Rs 1 crore call lifts it to Rs 5.48 crore, and three more years at 12% give about Rs 7.70 crore. He pays Rs 3.2 crore now and Rs 1 crore in year one and receives Rs 7.70 crore in year four: an IRR of 17.4% and a money multiple of 1.83 times. A buyer paying full NAV would earn exactly the fund's 12%, so the discount adds about 5.4 points.

Buy at a discount, meet a call, exit at NAV: the discount is one gain, growth anotherYear 0Year 1Year 2Year 3Year 4Pays Rs 3.2 crfor Rs 4.0 cr of NAVdiscount Rs 80 lakhCapital call Rs 1 crReceives Rs 7.70 crNAV grown 12% a yearIRR 17.4%, money multiple 1.83xAt NAV instead: IRR 12.0%, 1.54x
Jaideep pays Rs 3.2 crore for Rs 4 crore of NAV and a Rs 1 crore call in year one, and receives about Rs 7.70 crore in year four, an IRR of 17.4% against 12.0% for a buyer at NAV.
YearCash flow, Rs croreNAV at year end, Rs crore
0-3.204.00
1-1.005.48
26.14
36.87
4+7.707.70
Rs 4.2 crore paid in over two dates returns Rs 7.70 crore in year four; Rs 3.50 crore of profit, of which the Rs 80 lakh discount is the part a buyer at NAV would not get.
Step 3When is the discount not a gain at all?

When the NAV is stale or generous. A private fund's NAV is the manager's estimate, often months old, and sellers of stakes at a discount sometimes know something the NAV does not yet show. If the true value is 10% below the stated NAV, his IRR falls to 14.8%; at 20% it is 12.0%, no better than the fund; at 30% it drops to 9.0%. Diligence therefore goes into the NAV: what the largest holdings are marked at, how comparable listed companies have moved since the valuation date, and why the seller is selling.

The discount is a return only if the NAV it is measured from is realNAV accurate17.4%NAV overstated by 10%14.8%NAV overstated by 20%12.0%NAV overstated by 30%9.0%12.0%: what the fund itself earns
If the stated Rs 4 crore NAV is accurate Jaideep earns 17.4%, but a 20% overstatement cuts that to 12.0%, the fund's own return, and a 30% overstatement to 9.0%.

Close with the judgement. The deal is attractive if the NAV holds up to scrutiny and he can meet the call without strain; the 12% growth is an assumption, and the year-four exit is a hope, since private funds often take longer to return cash, which lowers the IRR even if the multiple is unchanged. A secondary discount is the price of buying something hard to value and hard to sell, and it should be earned by checking the value, not assumed.

Where candidates lose it

Candidates add the 20% discount to the 12% growth and call it done, or forget the Rs 1 crore call entirely. The call is money in, in year one, and it dilutes the effect of the discount on the IRR.

The second miss is treating NAV as a market price. It is an estimate, and the discount is only a return if that estimate is right.

What the interviewer asks next

  • The fund returns the cash in year six instead of year four. What happens to the IRR and the multiple?
  • How would you check whether a Rs 4 crore NAV is stale?
  • Why would a seller accept 80% of NAV if the NAV were accurate?

Company names and figures are illustrative.