Private Equity IRR, Subscription Lines, and a Continuation Fund
Fund III, a 2016-vintage buyout fund, reports a 24% net IRR. It has called $100 million, distributed $140 million, and holds $60 million NAV, so TVPI is 2.0x and DPI is 1.4x. Due diligence reveals three adjustments: (1) $40 million of distributions were funded by a subscription credit line that delayed capital calls by nine months; (2) $25 million of NAV is a continuation fund that purchased two assets from Fund III at a 20% premium to the highest prior third-party bid; (3) the GP's fee calculation included $15 million of recallable distributions that may be clawed back. The GP is raising Fund IV and is offering existing LPs priority allocation if they commit before seeing the continuation fund's audited valuation.
1. Assess the reliability of the reported 24% net IRR and calculate simple adjusted metrics.
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The 24% IRR is not comparable to a conventional cash-flow IRR. The subscription line delayed capital calls by nine months, which shortens the period over which invested capital is measured and mechanically raises IRR. The continuation fund's $25M NAV is based on a 20% premium to the highest prior third-party bid; marking it to that prior bid would reduce NAV by $25M - ($25M/1.20) = $4.17M, to $20.83M. TVPI would then be ($140M + $20.83M)/$100M = 1.61x, not 2.0x. The $15M of recallable distributions should be treated as not yet final; an adjusted DPI would be ($140M - $15M)/$100M = 1.25x, with the $15M at risk. These metrics still show a decent fund, but the 24% IRR overstates the economic result. The LP should use PME, DPI, and NAV realism rather than IRR alone.
2. What conflicts and process problems arise from the continuation fund and the Fund IV priority offer?
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The GP has a conflict because it is both seller and buyer in the continuation transaction, and the $25M valuation is based on a premium to the prior bid rather than an independent current market check. Existing LPs need an independent fairness opinion, full disclosure of fees and carry in the continuation vehicle, and confirmation that the LP advisory committee approved the transaction without GP pressure. The Fund IV priority offer is a separate conflict: it conditions an allocation benefit on committing before the continuation fund's audited valuation is available. That compresses due diligence and may cause LPs to waive review of a related-party valuation. A prudent LP should refuse to commit before receiving audited valuations, demand the continuation fund's terms and valuation support, and assess whether the GP is using Fund IV fundraising to paper over Fund III issues. If the GP will not provide that information, the LP should decline the priority allocation.