We continue to see significant interest in NAV financing products in the US and European markets, which is reflected in the double-digit year-over-year growth in our transaction activity for these facilities to date. Compared to past years, there has been a noticeable increase in the number of new lenders willing to provide NAV financing (including banks and private lenders). In mid-2020, at the start of the pandemic, the spike in interest in sponsor NAV loans was anecdotally explained by (i) sponsors being reluctant to call capital from LPs during the uncertainty of the pandemic and (ii) the inability of private equity-backed companies to obtain affordable financing during the disruptions caused by the COVID shutdowns. Nonetheless, as these pandemic effects continue to fade and we transition to a very different macroeconomic environment, demand for NAV loans remains strong. Below is a high-level summary of some of the main features of NAV loans, many of which are the focus of our conversations with clients.
The appeal of NAV loans is not that NAV loans provide a silver bullet to a particular problem facing the alternative investment market as a whole. Rather, NAV loans can be structured/tailored to solve a number of problems. It’s this flexibility that makes this product valuable to sponsors and investors alike (and keeps loan structurers and their attorneys on their toes and up late at night).
To illustrate this from an outside attorney’s perspective, a typical request we often receive from lenders who want to explore adding NAV loans to their product offering is to provide them with a sample term sheet for them to review. Since NAV loans are not a single product, there is not yet a truly single term sheet. Instead, to start putting together the skeleton of a term sheet for a NAV loan, you need to know the following (among other things):
(i) what is the structure of the borrower, and where in the structure will the financing be provided;
(ii) is the facility a revolver or a term loan (or a combination thereof);
(iii) is the borrower a hedge fund, private equity fund, private debt fund, secondary fund, family office, etc.? ;
(iv) whether or not the facility is secure;
(v) what the underlying assets are and what obstacles apply to the pledge and potential seizure of those assets;
(vi) what is the holding structure of the investments and what jurisdictions are involved;
(vii) how will the underlying assets be valued and what will be the rights to obtain independent valuations;
(viii) what is the lender’s approach to borrowing base eligibility, concentration limits, etc.? ;
(ix) are there co-investors and where do they fit into the structure;
(x) will there be bullet redemption or amortization based on cash flow, LTV, time to maturity, etc.? ;
(xi) will additional credit support be provided, such as pledges of capital commitments, guarantees or capital commitment letters from parent funds;
(xii) will the facility be used to finance an acquisition or are the underlying assets already held;
(xiii) is the static investment portfolio (that’s to saypre-approved) or dynamic portfolio;
(xiv) and does the borrower have any other creditors.
When discussing NAV loans with clients who are new to the space, we typically describe these loans as falling into several broad categories:
Negative Pledge/Collateral Lite Loans: The first is very low loan-to-value facilities to larger, more diversified funds, where lenders generally do not take the investment assets as collateral, but rather guarantee the value of the fund as a whole (often coupled with a negative pledge of the fund’s assets and pledge of the fund’s bank accounts). See our colleague Leah Edelboim’s previous discussion of these types of setups here.
Fully Secured Loans: The second tranche comprises what are generally higher loan-to-value facilities or facilities to more concentrated funds (or subsidiary vehicles of such funds), where lenders will take security over the investment assets of the fund (often indirectly, as noted earlier here). These facilities tend to have much more structured collateral and credit support. In addition, since these facilities are underwritten based on the value of specific investments (rather than the value of the fund itself), it is imperative that lenders understand all aspects of the investments backing the loan, and the lenders may seek to lay out in detail an exit plan in the event of the institution’s failure. Check out our previous coverage here of common issues that arise when evaluating security structures for these types of loans.
Structured products: The third category is preferred stock or similar structured products where funding is provided to a fund in the form of a purchase of a security issued by the fund. The security may offer a fixed rate of return, a variable rate of return (usually linked to a benchmark or index) or a structured rate of return that depends on the performance of the fund’s assets. These structured products tend to appear in the middle of the capital structure, behind secured creditors but ahead of equity investors. They tend to have longer terms and higher rates of return. And they can be structured to differentiate returns between product holders, including by class or series. We’ll provide a more detailed discussion of these products on another day.
We also highlight common uses for these loans, including:
Added strategic investments. We commonly see structured NAV loans as part of a fund’s addition of strategic investments. These loans can be structured to provide acquisition financing or to provide leverage to a fund to finance the equity portion of its acquisition costs for the particular investment(s). These facilities are typically used later in the funds’ investment cycles, after capital commitments have been largely called or are no longer fully available.
Capital returns for investors. As the average holding periods of private equity portfolios increase, sponsors are under continued pressure to monetize their investments and provide liquidity to their investors. Accordingly, a common use of NAV loans is for sponsors to borrow at the fund level to return capital to investors. Lenders are repaid later after realization events with respect to one or more investments of the funds. In this case, a NAV loan allows the fund to return capital to its investors prior to one or more realization events relating to its investments.
Funding of management companies. General partners and management companies use NAV loans for a variety of purposes, including working capital, financing increased investments in the funds they manage, paying taxes, paying bonuses, technology upgrades , distributions to owners and estate planning (that’s to say, transferring interests in managed funds from founders to the next generation of investment professionals), to name a few. These facilities may be secured by fee flows from the funds or by equity investments in the funds.
Tracking facilities. For funds with ongoing liquidity needs after the expiration of their investment periods, some lenders will agree to extend a fund’s existing underwriting line facility subject to certain additional credit enhancements, including the borrowing base to increase borrowing capacity (for example, a substantial increase in borrowing base from a traditional blended advance rate of 50% to 90% is not uncommon). In return for this increased borrowing base availability, lenders will typically require the implementation of NAV type covenants to mitigate the reduced primary source of collateral and repayment in the form of uncommitted capital for these facilities and look “down” at the asset value of the fund’s investments. See our colleague Chad Stackhouse’s in-depth discussion of these types of setups here.
Facilitating Continuation Funds. The use of funding for continuation funds has received a lot of press lately. A continuation fund will be created to transfer the assets of an existing fund. Investors in existing funds can choose to either be cashed out of the investment or transfer their equity into the new fund alongside new and existing investors. The continuation fund’s purchase payment for the transferred asset(s) (which is used to pay exiting investors) may be partially financed by debt under a NAV loan.
Recession, war and interest rate hikes are among the many headwinds for markets in the months/years to come. It remains to be seen how the macroeconomic and political environment will affect sponsor appetite for NAV loans. While continued pressure on asset valuations may slow implementation, NAV loans are a natural tool to meet demand for liquidity from LPs and sponsors and as a supplement to equity in what will likely continue to be a challenging fundraising environment. It is the flexibility of NAV structures and their myriad applications for sponsors that serve as the best predictor for robust and continued growth.
© Copyright 2022 Cadwalader, Wickersham & Taft LLPNational Law Review, Volume XII, Number 266