It was a scenario seldom considered outside the confines of business continuity workshops. Whole sectors laid low by a global pandemic – portfolio company revenues, in some cases, crushed to zero overnight. When covid-19 first took hold in Europe and the US in March last year, GP attention turned immediately to liquidity. Urgent conversations quickly took place with existing lenders. But with risk appetite in the banking sector in question, chief financial officers also began to reach out to a small and little understood lending community, prepared to offer loans against concentrated pools of underlying net asset value.
“In those first three months, GPs were out there trying to ascertain their liquidity needs and understand their funding options,” says Matt Hansford, head of origination and NAV financing at Investec Fund Solutions. The firm experienced €4.5 billion of concentrated NAV enquiries in Europe in the first nine months of 2020, close to double the volume seen during the whole of 2019.
“By the end of the first half, enquiries were flying in from all over the place, as sponsors tried to understand what the capital needs of their portfolio companies were going to be and how those needs could be satisfied,” adds Dave Philipp, managing director of fund liquidity solutions at Crestline Investors. “At that point, the calls were primarily exploratory. CFOs were trying to figure out how concentrated NAV actually works.”
Around a third of those enquiries were ultimately resolved through government stimulus programmes, by recalling previous LP distributions or by working with new or existing direct lenders on an individual company level, Philipp explains. Another third had no immediate need. A final third, however, did translate into actionable deals.
In some cases, NAV loans were used to execute bolt-ons teed up prior to the pandemic, where the original debt had been pulled and the opportunity was too good to pass up. “Instead of financing that acquisition with debt at a portfolio company level, a fund finance structure was employed and then downstreamed so that the business could complete an all-equity deal,” says Philipp. The majority of concentrated NAV loans made in those early days, however, were about the safeguarding of liquidity.
“There was a lot of fear in the market, naturally, so the nature of the need was defensive,” says Doug Cruikshank, head of fund financing at Hark Capital, part of Aberdeen Standard Investments.
“There was a great deal of uncertainty about what was possible for companies operationally,” adds Thomas Doyle, partner at 17Capital. “Perhaps an existing capital structure didn’t work given reduced revenues, or a particular company or companies needed an injection of capital.”
Appeased by unprecedented state support measures, however, stock markets rallied remarkably. And as M&A activity rebooted in the post-summer months, GPs switched to exit mode, and the concentrated NAV market took a step back. But far from receding into the shadows, the intensive education process that had taken place had positioned NAV lenders perfectly to enter a new phase of growth.
In November and December, the focus of concentrated NAV had shifted markedly towards opportunistic situations. With generous furlough schemes and other support, many worst-case scenarios failed to materialise for sponsors, and GPs started to explore the possibility of buying smaller, struggling businesses at attractive valuations.
“As the stock market came back and PPP money, here in the US, started to flow, we saw a change, first from defence, to a combination of defence and offence, and then, in the last few months, almost entirely to offence,” says Cruikshank. “The M&A market opened up and sponsors saw the opportunity to strengthen their platforms with bolt-ons. And they wanted to be sure they were ready to take advantage of those opportunities as opposed to being on the backfoot.”
The same, of course, was true in Europe. “Buy-and-build has been by far the biggest theme for us,” says Hansford. “Existing portfolio companies that have weathered the covid storm now have the opportunity to bolt on companies that can really accelerate value creation. And they can be bolted on at attractive prices.”
From defensive to opportunistic and then, at last, to acceptance. “Concentrated NAV didn’t begin and end with covid. But there was undoubtedly a momentum that built up throughout last year that ended in a crescendo,” says Doyle. “The result is that this has now become just another tool. Instead of five separate refinancings at an individual company level, why not take out an NAV facility at the portfolio level? This has become an understood and accepted approach.”
This has certainly been evidenced by the types of firm participating in concentrated NAV deals. At least one large UK household name executed a “very attractive transaction in late summer”, Doyle says. “This is not the preserve of the badly managed group that needs to be dug out of a hole. There are top-quartile managers actively interested – the real crème de la crème.”
Philipp agrees: “We certainly saw more large- and brand-name borrowers come to the market in the second half. Previously, concentrated NAV tended to be the domain of lower mid-market franchises with aggregate AUM of $500 million to $5 billion. The last deal we did involved a firm with AUM of more than $1 trillion. Concentrated NAV has also extended beyond private equity, into real estate, credit and trust structures.”
Pushing back the parameters
The use of proceeds has also evolved. In addition to refinancing underlying portfolio companies and making last-mile funds available for bolt-on acquisitions or other expansion plans, sponsors are also using concentrated NAV loans for opportunistic buy-backs from minority shareholders, says Philipp.
“In times of liquidity stress, GPs may be able to take advantage of willing sellers if they are able to offer an all-cash bid, with no wraps, warrantees or due diligence, as they already own the business. That can be an attractive transaction for everyone and is something we expect to see more of.”
Hansford, meanwhile, is starting to see a pickup in the use of concentrated NAV as a means of creating distributions in a portfolio. Now that the brief exit bonanza that took place last autumn has eased, GPs will either have exited portfolio companies or decided that better value can be achieved in another year to 18 months, he says. “But LPs value velocity of distributions.”
The alternative of recapping multiple assets to achieve those distributions, meanwhile, is a lot of work. “Five different management teams tied up in lender processes. Five sets of due diligence. Five sets of legal documentation. Not to mention that increasing leverage levels in an individual business in a macro environment such as this may not be ideal,” Hansford explains. “Putting an NAV facility against the whole, or part, of the portfolio, can be a more effective way to send money back to LPs.”
Another emerging trend is the use of concentrated NAV for GP financing. Hansford expects to see this take off next year. “There is a lot of locked up value in funds and carry while managers wait to exit at the optimal time. But GPs are also successfully raising new funds that require their commitments, managing succession and expanding their franchises. Concentrated NAV loans can help the GP unlock some of that value to meet their needs.”
Getting LPs onside
Of course, the GP is not the only party that needs to be persuaded of the advantages of concentrated NAV lending. LPs have played an important role in bringing the product into the mainstream over the past year.
In general, LPs are supportive of concentrated NAV loans, so long as the transaction makes sense, says Philipp. “You have to articulate a clear use of proceeds and have a defined duration of typically one to three years. You need to be able to explain what you are going to do with the capital and how much that will save you in NAV, if it is a protective trade; or how much NAV you are going to be able to buy at a discount, if it is accretive. Here is the cost. Here is how long it is going to be outstanding. And here is our level of confidence that we will be able to pay it off within that period.
“If, as a GP, you can walk an LP though that thought process, the majority will be willing to go forward. By contrast, there has been pushback where the leap of faith has appeared too great.”
But even as LPs become increasingly accepting of concentrated NAV lending in principle, the circumstances and motivations of individual investors are likely to differ. “We see situations where some LPs would like to put in new capital themselves, while others are unable to participate due to liquidity issues and favour a fund finance facility,” Philipp says. “We are able to provide solutions that satisfy both sets of requirements.”
Transactions are starting to emerge where some existing LPs actually participate in the concentrated NAV structure itself. Crestline has recently closed one such deal. Philipp adds: “All LPs recognised this was a good trade for the fund. Some also felt the transaction offered good risk-adjusted returns and wanted to come in alongside us. I can imagine that becoming an increasingly important trend.”
There is no doubt that the concentrated NAV market has had to grow up fast in light of covid. The industry has experienced a dramatic rise in demand, has developed in size and sophistication and is already evolving into new use cases and structures.
It seems almost inevitable that the unprecedented attention the sector is receiving will lead to a spate of new entrants. But the handful of pioneering lenders that have dominated this nascent industry in recent years are sanguine about the prospect of more competition.
“Do I expect to see more competition? Absolutely,” says Doyle. “But for now, supply is extremely limited. The big banks, for example, are only interested in servicing their multibillion-dollar clients who make them hundreds of millions a year in M&A fees. You have to remember, after all, that the [risk-weighted asset] treatment for these types of loans are highly restrictive.”
Those secondaries players that have dipped their toes in this market – while trade volumes in their own industry have been down due to uncertainty and difficulties agreeing on price – are unlikely to stick around for long. “They have vacationed in this space but their cost of capital is much higher than an NAV-based facility,” Doyle says. “Once the secondaries market returns to normal, I think that interest will dissipate.”
Philipp adds that while he expects to see more competition, he also expects growth on the supply side to continue to outstrip demand. “Our target opportunity set – funds older than five years and the assets held within those funds – is set to grow as covid, once again, extends holding periods.”
Cruikshank agrees: “This is a market that is here to stay. There is a lot of work that needs to be done in middle-aged funds – problems to be fixed, winners to grow and the need to earn out the high multiples that have so often been paid. We can provide the liquidity needed for the GP to execute on that and to generate the returns that LPs are demanding.
“Covid has undoubtedly brought NAV lending to the fore, but concentrated NAV is not the product of covid. This is a natural progression of liquidity provision across the life of a fund. I have no doubt that it is an enduring trend.”
There are certain issues that any private markets CFO is going to want to get comfortable with before committing to a concentrated NAV deal.
There is price, of course, although none of the providers Private Equity International spoke to believe this to be a primary area of dialogue. “Like it or not, price is something everyone understands,” says Crestline’s Dave Philipp. “CFOs want to understand the true terms, beyond cost.”
Instead, Crestline has seen CFOs focus more on flexibility of structure. For example, delayed draw structures and revolving structures, which mean they can secure a facility but be flexible on when they draw or deploy the capital. Repayment terms are another key issue. Uncertainty continues to be pervasive as we begin another year blighted by covid. It can be hard for a CFO to predict when capital markets will come back into line and they will be able to sell assets outright. “Flexibility around repayment terms have been one of the more prevalent negotiation points.”
Aberdeen’s Doug Cruikshank agrees. “The first question a CFO will have is when do I have to pay this back? Is it first dollar out or is there some flexibility?”
Although some CFOs may want to hold on to the capital for a little longer, others have questions about prepayment flexibility. Cruikshank adds: “A lot of the situations being financed are transitional. It could be a bolt-on for a platform that could be sold relatively quickly, for example. The borrower doesn’t necessarily want to be locked into a long-term piece of capital. The ability to pre-pay some or all of the loan at a reasonable or no-call protection level is important.”
CFOs are also concerned about security – many NAV lenders require security across the whole portfolio, but others do not. The way covenants work is also key. “The way we structure these deals means there are a number of different gates to go through until a typical debt default, where the lender can step in, is reached,” says Investec’s Matt Hansford. “Having those gates is designed to leave the GP in control – to solve the issues themselves, in the first instance. As the borrower passes through those gates there will typically be pricing step ups to ensure the increased risk is factored in. But critically, the first control rests with the GP and we will work with them to create the right level of headroom to solve any issues.”