The Institutional Limited Partners Association (ILPA), a trade group for institutional investors in the private equity industry, recently published guidance for LPs and GPs concerning fund-level NAV facilities. See here for the full guidelines. In our view, these guidelines are a helpful starting point that we hope will prompt constructive discussions among GPs and LPs to educate LPs as to the mutually beneficial uses for these facilities while also sensitizing GPs to the reasonable transparency needs of LPs.

Overview of Current Market

ILPA broadly defines "NAV-based facilities" as any "credit facilities that are backed by the value of the fund’s investments". According to estimates by the Fund Finance Association, the market for these facilities is currently US$100 billion and is expected to reach US$600 billion by 2030. Eighty percent of NAV-based facilities have been used to support portfolio companies, while the remaining 20% have been used to fund distributions to investors.

ILPA notes, rightly, that, compared to credit funds, secondary funds and closed-end real estate funds which have used NAV-based facilities for many years, the use of NAV-based facilities by private equity sponsors is a relatively nascent phenomenon. Importantly, the ILPA guidelines only pertain to private equity funds; they are not intended to address the use of NAV-based facilities by other types of funds. Moreover, ILPA itself admits that NAV-based facilities can be structured in numerous different ways and for a variety of purposes, so the guidelines "are not intended to be universally appropriate or applicable".

Investor Concerns

The ILPA guidelines highlight several key concerns of LPs regarding the use of NAV-based facilities:

• LPs often have limited insights into when and for what purposes NAV-based facilities are being used;
• LPs struggle with the lack of governance related to the use of NAV-based facilities, which drives the lack of transparency;
• Where the LPA is silent on entry into and incurrence of obligations in connection with NAV-based facilities, GPs have taken different approaches to how they treat NAV-based facilities;
• Some GPs have interpreted traditional fund-level leverage provisions in LPAs as providing sufficient authority for them to undertake NAV-based facilities without LP or LPAC notification or engagement; and
  LPs have observed increased use of NAV-based facilities during the more challenging fundraising environments of recent years.

In addition, when NAV-based facilities are used to fund distributions to LPs, there are concerns over potential adverse tax impacts for US taxable investors, misalignment of GP and LP interests due to management fee "Distributions to Paid in Capital" (DPI) ratio implications and the extent to which amounts distributed are recallable.

The press with respect to NAV-based facilities consistently calls out the use of these facilities to fund distributions as the chief source of consternation for LPs. Given that the use of NAV-facilities to fund add-on investments, "right-size" portfolio company leverage and for other value-adding purposes vastly outweigh their use to fund distributions, these concerns seem misplaced. The fact this this is such a point of focus for LPs does, however, highlight the need for greater GP/LP dialogue concerning how these facilities are used, when they are appropriate – or not, what conditions should apply to their use and what disclosures LPs should be entitled to receive. To the extent the ILPA guidelines are intended to instigate those discussions, we view them as a positive development.

ILPA Recommendations

For older funds, which are often the ones for whom NAV-based facilities are most useful, the majority of LPAs are silent regarding whether NAV facilities are permitted. Many GPs take the position that, in the absence of an express prohibition, NAV facilities are permitted. In addition, where a proposed NAV-based facility at the fund might breach or put undue pressure on fund leverage limitations, many GPs have taken the position that a NAV-based facility taken out at an aggregator vehicle beneath the fund is not subject to the LPA debt limitations. Other GPs have taken a more cautious approach and actively engaged their LPACs and/or broader LP base in discussions regarding proposed NAV facilities to ensure investor buy-in prior to implementing a NAV-based facility.

Rather than recommending that LPs actively seek to prohibit or curtail the use of NAV-based facilities, as many market participants might have feared, the ILPA guidelines concentrate instead on recommendations for greater LP/GP communication, both at fund inception and when certain NAV-based facilities are being considered.

In the first instance, the ILPA guidelines recommend that express provisions addressing NAV-based facilities be incorporated into new LPAs so that the rules governing such facilities are clear from the outset and investors have the information needed to assess the aggregate potential leverage a fund can incur and, hence, the riskiness of an investment in that fund vis-à-vis others.

As to the content of those rules, the ILPA guidelines have two primary themes: LPAC engagement and disclosure. The guidelines recommend that, absent clear authority in the LPA to enter into a NAV-based facility, the GP seek LPAC consent for the facility regardless of its intended use. In the case of NAV-based facilities used to make distributions to investors, the guidelines recommend the GP seek LPAC consent even if it already has clear authority to enter into NAV-based facilities generally. The guidelines recommend that the engagement with the LPAC include at least:

• The rationale for the facility and intended use of proceeds;
• The size, structure and controls;
• Key economic terms; and
• Resulting LP obligations (such as recallable capital), if any.

Overall, we see this as a measured approach to encourage communication between GPs and LPs and ensure that the GPs’ need for flexibility in managing the portfolio, including incurring fund-level debt, is balanced fairly against the LPs’ need for transparency. Ultimately, we are confident that with additional GP/LP engagement and education, the benefits afforded by NAV-based facilities and the value-enhancing opportunities they provide will be apparent to the LP community and ensure that the market for these facilities continues to grow.