Fund finance is on the up. The breadth and depth of both supply and demand are increasing rapidly. With demand for subscription lines at around 20-30 percent of the more than $1 trillion that closed-end private markets funds have been raising annually, the fund finance industry is clearly experiencing exponential growth.
Only two years ago, the accepted ceiling for the subscription line market globally was $500 billion, a figure now seen as a wild underestimate.
So just how big can this market get? Of course, the answer is determined in part by the scale of the private capital industry itself. After all, the number of domestic companies listed on US exchanges has slumped by 40 percent from its peak, while private markets firms raised a record $1.18 trillion in 2021, according to McKinsey.
“The financing needs of funds are increasing as the funds themselves grow,” says Pierre Maugüé, corporate partner at Debevoise & Plimpton. “We have seen multi-billion-dollar subscription line facilities simply because the funds themselves are so enormous.”
Of course, market growth requires additional supply, as well as demand. The banking sector, which has traditionally dominated the subscription finance market, does not have unlimited capacity and may even have to rein back its appetite in a more volatile economic environment. However, additional liquidity is now being provided by institutional players – insurance companies in particular.
“There has been a big increase in non-bank allocations to this market as a result of the introduction of credit ratings,” says Ian Wiese, portfolio manager within MassMutual’s direct private investments team. “That is enabling more sources of capital to enter the space.”
Brian Foster, partner at Cadwalader, adds that in addition to non-bank lending growth in the market, capital relief trades are starting to aid in balance sheet constraints, helping some banks to keep up with liquidity demand. Foster believes the subscription line market alone is worth $750 billion.
It is the more nascent NAV market that is poised for a spike. “There has been a lot of education of GPs, and in turn LPs, in the use of this form of financing, and that has proved key to increased adoption,” says Wiese.
Structured solutions can provide much needed liquidity without forcing LPs to crystalise a loss, with NAV financing seen as an alternative to the LP-led secondaries sale.
The private equity market is seen by many as an indicator of where private debt could be heading in terms of NAV financing over the next decade.
From late 2021, large North American investors started selling part of their LP book to create capacity to invest in new vintages as capital calls started to outweigh distributions.
“The financing needs of funds are increasing as the funds themselves grow”
Debevoise & Plimpton
“The trend has only accelerated as rates have risen and public markets have sold off, creating large overexposures to alternatives, known as the denominator effect” says Fokke Lucas, partner at 17Capital. “The majority of these situations, perhaps 80 or 90 percent, will be solved through the traditional secondaries sales where LPs are accepting discounts in the 10-25 percent range. But we are also seeing situations where LPs need to manage exposure but don’t want to take that hit and don’t want to give up the relationships they have invested in with sponsors.”
This is where NAV financing comes in. Appetite for structured solutions including NAV financing really began to emerge in Q3 and Q4 of last year, when a number of large books of LP interests were taken to market but failed to reach the seller’s reservation price. In many cases, there were underlying issues in the portfolio and the discounts offered to reflect perceived quality were deemed unpalatable.
Of far more interest to a bourgeoning group of specialists, however, are the deals now emerging where the objective is overwhelmingly access to liquidity. “There are investors that don’t want to be forced to sell assets at the wrong point in the cycle. They want to maximise liquidity without forgoing future upside,” says Michael Hacker, global head of portfolio finance at AlpInvest Partners.
“They are therefore looking for a form of financing that isn’t overly punitive and so are putting their best assets forward.”
“We are definitely starting to see NAV solutions offered to LPs facing liquidity issues where the investor doesn’t want to sell at a double-digit discount,” adds Gerald Cooper, partner at Campbell Lutyens. “NAV financing, particularly where there is conviction that performance in the medium to long-term will be strong, can often make sense.”
The other advantage of a NAV financing is that it is significantly easier and quicker to execute on than a traditional secondaries sale. “Transferring a book of 25-50 LP interests can easily take nine months,” says Lucas. “In a preferred equity or NAV deal there is no seller, so the investor of record remains the same. These transactions can be done in six to eight weeks which is unheard of in the secondaries market.”
A NAV financing also sidesteps the bid ask spread that is currently thwarting many secondaries sales because buyer and seller don’t actually need to agree on value.
“If the NAV of a portfolio is 100, the secondaries market may offer 75,” Lucas explains. “We can structure the deal based on a NAV of 100. The cash we put in up front may be lower, we may not lend 75 against it. But it’s a much smoother discussion because as lenders there is no change of ownership and so no real need to come together on the value of the last dollar.”
NAV lending in secondaries is expected to soar over the next decade. The market for NAV-based financings is estimated to fall between $80 billion and $100 billion today, with around $30 billion of transactions completed in 2022 alone, according to Dave Philipp, partner at Crestline Investors. “This market has more than doubled in the last two years and continues to see tremendous growth and acceptance, similar to the growth in the LP and GP-led secondaries markets.”
Darren Schluter, managing director in the secondary advisory group at PJT Park Hill, adds: “We estimate 20-30 percent of secondaries transactions are currently utilising NAV financing in some format, whether that is true NAV financing or a hybrid facility, which would indicate $25 billion-$30 billion in financing per year. The growth of NAV financing is outpacing the growth of the secondaries market as these structures have increased in adoption.”
The drivers behind NAV financing adoption are changing, however. Historically, financing was used to enhance returns across most secondaries strategies. This became more prolific when rates were low and competition for deals was high.
“There are investors that don’t want to be forced to sell assets at the wrong point in the cycle”
“But today’s macro environment is slowing asset sales, putting liquidity pressure on secondaries portfolios that are now looking to NAV loans to provide synthetic distributions to LPs and/or bridge timing mismatches between proceeds from asset sales and capital commitments,” says Philipp. “Another element driving more non-bank NAV activity is the growth of GP-led secondary portfolios, especially those that focus on single asset continuation vehicles. As these portfolios begin to resemble private equity funds from a diversification perspective, non-bank lenders become more relevant.”
There are two primary advantages of incorporating a NAV loan to support the acquisition of a secondary portfolio. The first is that the cost of a NAV loan should be less than the expected return of the secondary portfolio, leading to a yield pickup should everything go according to plan.
“A second advantage is that NAV loans can be used as a bridge to allow an adviser more time to pull together an optimal equity stack. Utilising NAV loans as a bridge is more prevalent right now, especially in more complex transactions that take longer to complete,” says Philipp. “NAV loans are an increasingly valuable tool where there is an expected near-term exit within the portfolio.”
But while growth in the NAV financing market has been explosive, continued downward pressure on company valuations and lagged marks may constrain the number and volume of secondary transactions overall. “Our conviction is that these risks are likely to be outweighed by the market growth provided by the increased knowledge of NAV based portfolio financings and expanded use of proceeds,” says Philipp.
Indeed, Crestline believes that the NAV financing market is still in the early-to-mid innings of development and is likely double in size over the next two to three years. The asset classes embracing NAV financing have expanded from buyouts, to venture, growth capital, real estate and infrastructure, while the borrower base has expanded from traditional secondary portfolios to include family offices, trusts and foundations that have identified liquidity needs as well.