NAV Facilities: A Portfolio Management Solution for a PE Fund’s Sunset Years (Part 1 of 2)

The massive growth of the private equity market over the last decade has meant an explosion in the number of private equity transactions. Thanks to the Law of Large Numbers, we now have a much better understanding of the friction points and potential capital inefficiencies inherent in the PE investing model than we did even before the Financial Crisis of 2008.

We’ve previously written about how subscription lines of credit and similar facilities can be used while a fund has callable capital; now we want to address a liquidity solution developed in response to the hurdles sometimes faced by more mature funds, the Net Asset Value (NAV) facility. To do this effectively, we’ve phoned our friends Dave Philipp and Amit Mahajan at Crestline Investors to bring you this two-part piece.

Crestline’s Fund Liquidity Solutions Group (“Crestline FLS”) provides custom financing and capital solutions to private equity funds and other private asset vehicles seeking additional capital to support, grow and protect underlying portfolio companies and opportunistically provide liquidity to investors. Dave and Amit are the expert originators of NAV facilities, so we appreciate their insight on the topic.

A Portfolio Management Solution // Financing Tools for the Sunset Years

As funds mature past the time in which they can call capital from LPs, new financing structures based on a fund’s NAV provide an efficient solution with the flexibility to address many of the challenges that can face a fund in its golden years.

Let’s start by considering the size of the potential market for this sort of facility. Private equity data aggregator Preqin estimates that the amount of unrealized NAV held in mature PE funds (i.e., 5+ years of age) grew 4x from 2008 to 2018, from approximately $400 billion to $1.7 trillion. 

Let’s say we apply a conservative loan-to-value (LTV) ratio of 15% on just 10% of that 2018 unrealized NAV. That would generate $25.5 billion in NAV loans to PE funds.

Supporting this growth in mature NAV is the fact that funds are holding onto their portfolio companies longer, often well beyond the typical 10-year PE fund life structure, with such funds receiving one, two or several extensions from investors. These lengthier fund lives are leading to an increase in funds managing significant portfolio holdings beyond the timeframe in which they can call capital from LPs to support their assets.

Given these dynamics, GPs are requesting NAV facilities from traditional banks now more than ever. They are often surprised when a traditional bank passes on providing a NAV facility, especially when the leverage level feels modest. The GPs’ view is that their fund will return at least the cost of the portfolio, so a facility at less than 50% of NAV should be a safe loan to offer. Well, we agree!  The GPs are not wrong to have this point of view, so what’s the main obstacle? TIME!

The Traditional Bank Point of View // Time is of the Essence

NAV loans are secured by the equity value of the assets across a fund’s portfolio. When the fund’s equity is realized through a portfolio company liquidity event, those proceeds are used as the repayment source for the NAV loan. The problem for banks is the inability to accurately predict the timing of the sale of a portfolio company; deals can fall apart after LOIs are finalized, IPOs can get delayed, board approvals required by outside third parties might not happen when expected, or the legal process to close the sale of a portfolio company can simply drag out.

Since traditional banks have a stated maturity date for their loans, they must have a clear and predictable source of repayment. When a traditional bank loan is not paid on time and the “can gets kicked down the road”, it can lead to uncertainty around the borrower’s ability to repay, compelling the bank to classify the loan as non-performing. The more non-performing loans a bank has, the more the banks have to reserve capital for potential loan losses. You see where this path is going… and needless to say, it’s not a path that banks want to go down. Banks are also held to other regulatory standards that make it difficult for them to structure a NAV facility with optimal flexibility. The requirement for regularly scheduled interest payments and the fund to maintain a cash reserve to service these payments is just one example.

Some banks specializing in lending to private equity funds have created ways to structure NAV facilities by adding additional sources of repayment. But these remedies may be sub-optimal from the borrower’s perspective, given that they are really looking for a lender to only consider the fund’s NAV as collateral.

The “hybrid facility” has been referenced in the market by traditional banks as a potential solution. The hybrid facility name sounds exotic, but it can just be code for a subscription line with a more aggressive advance rate against uncalled capital provided at the later stage of a fund’s life.  

 Non-traditional bank lenders, like Crestline, have more flexible capital that can result in the structure a fund really needs to bridge a financing gap when callable capital has dried up.

Applications for Mature PE Funds // A Wide Variety of Solutions

We’ve established that a NAV loan may be relatively accessible from a non-traditional lender and potentially desirable in comparison to other forms of capital. Now, let’s look at the issues this solution can address.

Financial opportunities and challenges for portfolio companies in later-stage funds can represent a hurdle at a point when relatively little fund capital is available to deploy.

One use of NAV loans is opportunistic, allowing GPs to act nimbly in situations where the larger fund may be running dry or where fund commitments are prohibited from being deployed.

• Loans can be used to provide new equity into portfolio companies presented with accretive add-on or platform-building opportunities.
• They can be used as a short-term, bridge-style financing for such acquisitions (to be refinanced out with cheaper long-term debt once pro-forma financials play out).

In these first two situations, traditional practice has been for funds to hold back 10% to 20% of their committed capital to pursue follow-on opportunities; the beauty of the NAV loan is that it frees up that reserved capital to be fully deployed in new opportunities that could further enhance LP returns.

• We’ve also seen NAV loans deployed to buy out departing fund LPs, co-investors or shareholders of portfolio companies. These opportunities allow a fund to provide a quick, compelling bid to motivated sellers on a shorter time frame than a new buyer due to the familiarity with existing assets.
• For even more creative applications, NAV loans have been drawn as bridge facilities to close secondary PE deals, including fund restructurings but only when GPs pledge their stake as well. Otherwise, the collateral for a more traditional GP loan would be fees and carry rather than NAV.

When portfolio companies are challenged, a NAV loan can function as a “patch” in some situations. A manager can borrow against portfolio value allowing a fund to:

• Inject new equity into a portfolio company to cure a covenant breach
• Avoid or participate in a follow-on financing at punitively dilutive terms that would otherwise allow new investors to cram down the equity position of LPs
• Last-mile financing for a portfolio company project or turnaround situation where third-party capital is not available or too expensive; getting debt at the portfolio company level can be a slow process and (in the event of a turnaround situation) expensive to underwrite

Younger PE Funds // Getting Even More Creative

NAV loans — they’re not just for middle-aged PE funds! Here are some ways we’ve seen them used at funds that are less than five years old:

• Warehousing of deals between fund closings (often when subsequent closings are taking longer than expected and a manager wants to remain active in the market)
• Warehousing of large deals where the GP needs capital to control the transaction upfront, and then take time after closing to optimize the right consortium of co-investors and final capital structure

Even non-traditional funds, like evergreen funds, interval funds, holding company and trust structures, pledge funds and fundless sponsors, can benefit from NAV facilities in the right situations — assuming they have existing assets to draw against. We’ve seen such entities use NAV structures to close on additional assets and then raise new capital at a higher value once those assets are in the portfolio.

A logical next question is whether a NAV facility is a good fit for your fund. In Part Two of this piece, coming next month, we’ll take a look at the underwriting parameters of NAV lenders, the cost-benefit considerations that should play into a decision on whether to draw a NAV loan and some real-world scenarios where we’ve seen NAV facilities put to work.

What are your thoughts on NAV facilities? Leave a comment and add to the discussion >

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