The holder of the right knows the portfolio better than the bidder, so the deals it lets through are the weaker ones. That selection, not the delay, is most of the cost.
A right of first refusal costs a secondary buyer twice: the diligence it pays for on deals it loses, and the deals it loses being the good ones. On an illustrative LP interest where the buyer could pay 88.0 per cent of NAV with no ROFR in the way, a holder who matches half the time, and only when the price is cheap, cuts the break-even bid to 84.8 per cent of NAV. Of that 3.2 point cost, 1.0 point is wasted diligence and 2.2 points are adverse selection.
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 →
Many LPAs require GP consent to a transfer, and some go further and give the GP, or the existing LPs, a right to buy the interest at the price the third party agreed. Buyers tend to treat this as a timing nuisance. It is a pricing input, because the party holding the right knows the portfolio better than the bidder and will use it selectively.
| Input | Value |
|---|---|
| Reported NAV of the interest | $40.0m |
| Buyer's required return | 15% |
| Buyer's diligence, legal and transfer costs, per bid | 1.0 |
| Probability the ROFR holder matches when the price is below value | 50% |
The buyer models three outcomes for the interest, each expressed as the present value of its net cash flows at 15 per cent. That present value is the price at which the buyer earns exactly its target before costs.
| Outcome | Probability | Value at 15% |
|---|---|---|
| Strong: the two lead companies exit as the GP expects | 25% | 100.0 |
| Base | 50% | 90.0 |
| Weak: one write-down, one delayed exit | 25% | 76.0 |
| Expected value | 89.0 |
The bidder does not know which outcome is true. The ROFR holder, sitting on the advisory committee or running the companies, has a much better idea.
Expected NPV = expected value − price − costs = 89.0 − P − 1.0.
Break-even price: 88.0, a 12.0 point discount, or $35.2m for the $40.0m interest.
Now add a holder that matches with 50 per cent probability, but only when the true value is above the price. At 88.0 that means the strong and base outcomes can be taken away; the weak one never is.
| Outcome | Probability the buyer closes | Gain on 88.0 | Contribution |
|---|---|---|---|
| Strong | 12.5% | 12.0 | 1.50 |
| Base | 25.0% | 2.0 | 0.50 |
| Weak | 25.0% | −12.0 | −3.00 |
| Costs, paid on every bid | −1.0 | ||
| Expected NPV | 62.5% | −2.0 |
The bid that was fair without the ROFR now loses 2.0 points of NAV in expectation. The interests the buyer closes on are worth 86.4 on average, not 89.0: the winner's curse, delivered by contract.
Between 76.0 and 90.0 the weak outcome is always won and the other two half the time, so:
NPV(P) = 0.125 × (100.0 − P) + 0.25 × (90.0 − P) + 0.25 × (76.0 − P) − 1.0
= 12.5 + 22.5 + 19.0 − 1.0 − 0.625P = 53.0 − 0.625P
Break-even P = 53.0 ÷ 0.625 = 84.8, or $33.9m.
In Excel, with probabilities in B2:B4, values in C2:C4, the match probability in E1 and the bid in F1, the NPV is =SUMPRODUCT(B2:B4,IF(C2:C4>F1,1-E1,1),C2:C4-F1)-1; Goal Seek F1 to zero.
| Step | Break-even bid | Cost, points of NAV | On $40.0m |
|---|---|---|---|
| No ROFR | 88.0 | ||
| Holder matches at random, half the time: costs wasted on lost bids | 87.0 | 1.0 | $0.40m |
| Holder matches only when cheap: adverse selection | 84.8 | 2.2 | $0.88m |
| Total cost of the ROFR | 3.2 | $1.28m |
The wasted-cost part is the one buyers negotiate over, and it is the smaller one. If the seller or the GP reimburses the buyer's costs whenever the right is exercised, the break-even bid rises only to 85.4, recovering 0.6 of the 3.2 points. That is less than the 1.0 point attributed to wasted costs above, because with an informed holder the buyer loses fewer bids than in the random case, so fewer costs are wasted; the split between the two effects depends on the order in which they are added. The adverse selection stays, because it comes from who keeps which deals, not from who pays the lawyers.
| Match probability | Holder matches at random | Holder matches only when cheap | Cost of the ROFR | Probability of closing |
|---|---|---|---|---|
| 0% | 88.0 | 88.0 | 0.0 | 100.0% |
| 25% | 87.7 | 86.8 | 1.2 | 81.2% |
| 50% | 87.0 | 84.8 | 3.2 | 62.5% |
| 75% | 85.0 | 81.1 | 6.9 | 43.8% |
| 90% | 79.0 | 76.9 | 11.1 | 32.5% |
| 100% | no deal | no price works |
The cost is convex. At low match rates it is a few tenths of a point; once the holder is a GP with an affiliated buyer ready to step in, it approaches the size of the whole discount. At 100 per cent the market breaks: whatever the bid, an informed holder takes every interest worth more than the price and leaves the buyer only the ones worth less. That is why bidders ask, before spending on diligence, whether the right has been waived or whether the holder has said it will not exercise.
Buyers price the interest on the full distribution of outcomes and then treat the ROFR as a probability of not closing, as if losing a deal were neutral. It is not neutral when the other party chooses which deals you lose. The right comparison is the value of the interests you will actually own, conditional on the holder having passed. On these figures that conditional value is 86.4, 2.6 points below the unconditional 89.0. The bottom-up NAV work in pricing an LP interest on a bottom-up NAV gives the outcomes; the ROFR decides which of them you keep.
Diligence point: ask who holds the right, whether it can be assigned to an affiliate or another LP, how long the exercise window is, and whether it has been used on earlier transfers. A holder that has never exercised is closer to the random case; one that exercised on the last two sales is close to the informed case, and the bid should move accordingly.
Price a ROFR as a selection mechanism, not a delay. Here it moves the break-even bid from 88.0 to 84.8 per cent of NAV, and cost reimbursement wins back only 0.6 of that. The seller's side of the same negotiation is set out in why a secondaries bid-ask gap often has no zone, and the book's deal model, with the return split between discount and growth, is in the free workbook for this case.
A term in some LPAs or side arrangements that lets the GP, or the other LPs, buy an interest being transferred at the price a third party agreed. In the illustrative case a holder that uses it half the time, and only when the price is below value, lowers the bid at which a buyer breaks even from 88.0 to 84.8 per cent of NAV.
Only partly. Reimbursing the bidder's diligence and legal costs when the right is exercised removes the wasted-cost part, but not the selection: the holder still keeps the interests worth more than the price. In the illustrative case reimbursement lifts the break-even bid from 84.8 to 85.4, recovering 0.6 of a 3.2 point cost.
Because the buyer closes on every interest worth less than its bid but only on some of those worth more. In the illustrative case, at a bid of 88.0 the interests the buyer ends up owning are worth 86.4 on average, against 89.0 across all outcomes, so a bid that was fair without the right loses 2.0 points of NAV in expectation.
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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