The case for NAV-based lending

The covid-19 crisis has been widely reported as an accelerator of pre-existing trends. Within private equity, one manifestation of this is the growing trend towards fund financing transactions over the past nine months and, in particular, net asset value-based loan facilities.

The case for NAV fund financings

NAV facilities are typically used for two principal purposes by private equity fund managers, either in isolation or combined.

First, these facilities provide access to additional capital for fully drawn funds to support further equity investment in current portfolio companies. This capital can be used for accretive acquisition or other growth opportunities, or to meet funding requirements from near term trading challenges, which have arisen in each case as a result of the dislocations of the covid-19 crisis.

Second, managers may choose to use these facilities as a source of accelerated liquidity to investors. This enhances the distribution to paid-in and internal rate of return of existing funds and enables performing assets to be held for longer. The net effect is that the fund benefits from continued earnings growth without suffering from unfavourable DPI benchmarking.

In any market, these benefits would be potentially significant prizes – but the current less certain and more volatile environment renders them all the more valuable to both LPs and GPs.

Known unknowns

GPs and LPs alike typically have less experience of NAV fund financing solutions than other credit instruments used to enhance private equity returns. It is worth taking a step back to consider the context as to where such facilities sit in the overall fund capital structures, when they may become relevant, why they might represent the optimal solution and what the potential constraints to introduction might be.

Subscription lines, sometimes known as capital call facilities – secured against the undrawn commitments of limited partners to funds – are now near universal means by which GPs use a credit solution to enhance the IRR of private equity funds, and reduce the volume of drawdowns for their investors.

The principle of fund investors accepting a capital cost – a MOIC reduction – at the fund level in return for IRR enhancement is therefore already well established. Subscription lines, however, are closely focused on the early years of fund life as commitments are drawn down during the investment period. It follows that the principle of future asset-based borrowing at the fund level, widely applied for many years in liquid strategies, should similarly be uncontroversial.

What about preferred equity?

Preferred equity, which has been used historically as a means of creating fund level liquidity, is provided by specialist funds with higher target returns than NAV facilities. These higher-cost solutions can make sense where the amount of liquidity sought is higher as a percentage of the fund net assets than the level at which NAV facilities will be available (usually around 20 percent) or where a more flexible structure and covenants are required.

Select GPs who have explored preferred equity solutions with their LPs during the pandemic have received resistance. Why so? Introducing capital provided by investors with similar return targets to existing fund LPs, which would then rank ahead of them on assets which they own, needs to be carefully assessed on a number of levels. Such a proposal can require a truly compelling incremental return case.

Market acceptance for NAV financing

As awareness and understanding increases, NAV fund financing is therefore growing in popularity with private equity funds.

Pierre Garnier, investment vice-president at 17Capital, a pioneering firm in providing portfolio financing solutions, observed: “Pursuing portfolio financing no longer makes you an outlier, as top-tier GPs are increasingly using it for a wide range of purposes, and the covid-19 pandemic has accelerated this long-term trend. Alignment of interests is vital and so it is important to ensure the financing will be value accretive for all stakeholders.

“If you have strong relationships with your investors, good performance, and a situation where the financing will result in equity returns above the cost of capital, LPs will often be supportive of portfolio-level financing, whether it is via NAV-based credit or preferred equity”.

Asset leverage is one of the defining and ubiquitous features of private equity investment. Reporting debt multiples without detailed analysis of covenants, security and quality of earnings is, however, a blunt measure of portfolio risk and individual company resilience to market or trading environment dislocation.

NAV facilities are likely to form an optimal financing solution for GPs near or after the end of the investment period. At this point, subscription lines have been fully utilised, but the manager may have conviction on significant future value creation potential to be derived from holding a material number of assets in the portfolio for a minimum of three further years – optimising the impact of the credit facility on final fund performance.

Is NAV fund financing for you?

For any GP considering a NAV financing, we would encourage detailed analysis of the cost to generate comparable liquidity at the asset level and the additional risk introduced to the capital structures of the relevant portfolio companies. NAV facility solution providers’ due diligence and portfolio analysis is, in our experience, a happy combination of swift and sophisticated. Asset performance, portfolio diversification and capital structures all affect both pricing and covenants and will determine the overall attractiveness and flexibility of the solutions available.

Fund financing solutions are not a panacea or by any means the optimal solution in all circumstances: material potential obstacles to be navigated include limited partnership agreement constraints; regulatory restrictions on fund leverage in any form in certain jurisdictions; tax – as ever; portfolio construction; and LP perspective.

However, as solution providers become ever more flexible and innovative, inasmuch as it is safe to forecast anything in the current world, it feels safe to predict both that fund financing facilities will become an ever more familiar – and popular – feature of the private equity fund landscape.

Magnus is Rede’s head of transactions, advising clients on GP-led secondaries transactions. Prior to joining Rede Partners Magnus was chief of staff to Lord Rothschild and responsible for the private equity and venture capital investment programmes for the Rothschild family and philanthropies.