An annex fund is offered as extra exposure on cheap terms. The price at which it buys into the existing companies decides whether declining is neutral or a gift to the LPs who invest.
Work out the price at which the annex buys into the existing companies, because that price decides who pays whom. In an illustrative case an annex putting $150m into companies the main fund holds at $600m, at a 10 per cent discount to fair value, moves $13.04m of value from the main fund to the annex on day one. An LP with 5 per cent of the fund that declines loses 2.17 per cent of its NAV; one that takes its pro rata share of the annex is hedged, apart from $0.10m of annex carry at exit.
Worked in full in The Private Markets Limited Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An annex fund (sometimes called a top-up or support fund) is raised when a fund has run out of dry powder but its companies still need capital. The existing LPs are usually offered the right to participate, on lighter terms than the main fund, and the LPAC is normally asked to approve the conflict. The question an LP faces is framed as "do we want more exposure to these companies?" It is also, and first, "at what price is the annex coming in?"
| Input | Value |
|---|---|
| Main fund commitments | 500.0 |
| LP's share of the fund (commitment of 25.0) | 5% |
| Fair value of the fund's holdings in the companies | 600.0 |
| Annex investment, as new shares | 150.0 |
| Annex price: discount to fair value | 10% |
| Annex terms: fee on invested capital, carry, no hurdle | 1%, 10% |
| Exit: post-money value grows, over 4 years | 1.6x |
Value the pre-money equity as 600.0 units at 1.00. At a 10 per cent discount the annex buys at 0.90 a unit: 150.0 ÷ 0.90 = 166.67 new units.
Annex ownership: 166.67 ÷ (600.0 + 166.67) = 21.74%, against 20.00% at fair value (150.0 ÷ 750.0).
Post-money equity is 600.0 + 150.0 = 750.0. The annex's stake is worth 750.0 × 21.74% = 163.04, the fund's 586.96.
Transfer: 163.04 − 150.0 = 13.04, a 2.17 per cent dilution of the fund's NAV in those companies.
For the LP, 5 per cent of the fund's 600.0 is a NAV share of 30.0. Declining costs it 5% × 13.04 = 0.652, 2.17 per cent of that NAV. Taking a pro rata 7.50 of the annex gains it exactly the same 0.652 on the annex side. On day one, pro rata participation is a perfect hedge.
| Annex price | Annex gross | Annex carry | Annex net | Net multiple | Net IRR | Main fund share |
|---|---|---|---|---|---|---|
| 10% below fair value | 260.87 | 10.49 | 244.38 | 1.629x | 13.0% | 939.13 |
| At fair value | 240.00 | 8.40 | 225.60 | 1.504x | 10.7% | 960.00 |
The discount has grown with the companies: the main fund ends with 20.87 less than it would have at a fair price. For the 5 per cent LP:
| LP decision | Main fund | Annex | Net versus a fair-price annex |
|---|---|---|---|
| Declines | −1.04 | −1.04 | |
| Takes its pro rata 7.50 | −1.04 | +0.94 | −0.10 |
The residual 0.10 is the annex GP's 10 per cent carry on the transferred value, which the LP pays as an annex investor but cannot recover as a fund investor. The main fund's own carry is ignored here; if the fund is in carry, the GP shares part of the main fund's loss.
| Discount to fair value | Annex ownership | Day-one transfer | Fund NAV dilution | LP declines: day one | LP declines: at exit | LP takes pro rata: at exit |
|---|---|---|---|---|---|---|
| 0% | 20.00% | 0.00 | 0.00% | 0.00 | 0.00 | 0.00 |
| 10% | 21.74% | 13.04 | 2.17% | −0.65 | −1.04 | −0.10 |
| 20% | 23.81% | 28.57 | 4.76% | −1.43 | −2.29 | −0.23 |
| 30% | 26.32% | 47.37 | 7.89% | −2.37 | −3.79 | −0.38 |
Two readings follow. If the annex comes in at fair value, there is no transfer, and the decision is an ordinary one about concentration and the annex's own return. If it comes in at a discount, declining is not a neutral choice: it is a decision to give value to whoever does invest. And the discount is not hypothetical. Annexes are usually raised when no outside investor will price a round, which is exactly when the GP's estimate of fair value is weakest.
LPs often judge the annex only by its headline net IRR, here 13.0 per cent, and compare it with their hurdle for new commitments. Part of that 13.0 per cent is not return from the companies; it is value taken from the main fund, much of it from the same LP. At a fair price the annex earns 10.7 per cent. An LP that sees the 13.0 per cent and invests more than its pro rata is buying the transfer from the other LPs; one that declines is selling it to them at no price. The right question for the LPAC is what evidence supports the price, for example an outside co-lead or a recent third-party mark, rather than whether the annex terms are cheap.
Check before deciding: the annex price per share against the latest fund mark, whether a third party invests on the same terms, and whether non-participating LPs are protected by anything other than the LPAC's consent.
Price first, exposure second. A 10 per cent discount moves 13.04 from the main fund to the annex; pro rata participation hedges an LP to within 0.10, and declining costs it 1.04 by exit. The reserve-side version of the same question is in what a follow-on reserve is actually worth, and the book's co-investment economics are in the free workbook for this case.
A vehicle raised when a fund has used its commitments but its companies still need capital, usually offered first to the existing LPs on lighter terms. In the illustrative case it invests $150m alongside holdings worth $600m, with a 1 per cent fee on invested capital and 10 per cent carry.
Only if it buys below fair value. At a 10 per cent discount the annex acquires 21.74 per cent of the companies for $150m instead of 20.00 per cent, moving 13.04 of value from the main fund. An LP with 5 per cent of the fund that declines loses 0.65 on day one and 1.04 by exit at 1.6x.
Almost. On day one the gain on the annex side exactly offsets the dilution in the main fund. At exit the annex GP's carry takes 10 per cent of the gain on the transferred value, so the illustrative 5 per cent LP ends 0.10 behind a fair-price annex, against 1.04 if it had declined.
This article is one calculation from The Private Markets Limited Partner. 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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