Loans to private investment funds based on the net asset value of their respective portfolio investments (that is, total assets of such a fund less its liabilities) have become dramatically more popular in recent years, as have similar arrangements structured as senior equity rather than debt. NAV loans have existed for more than a decade, and their increased use coincides with growth in the private investment funds industry and related expansion in demand for capital solutions. This post provides background information on NAV loans, discusses key issues for consideration by fund managers in connection with utilizing NAV loans and highlights due diligence points for fund investors related to NAV financings.
Use Cases for NAV Financing
NAV financing is provided by banks and non-bank lenders and used by numerous varieties of closed-end funds, including real estate, buyout/private equity, credit, venture and infrastructure funds. Such funds typically have a set investment period, during which they make investments by drawing down investors’ capital commitments. Most market participants are familiar with revolving subscription credit facilities for investment funds, in which a fund’s right to call capital from its investors serves as collateral for the loan. Subscription credit facilities are often used to bridge capital calls, finance other operations and provide liquidity at the fund level early in an investment fund’s life, typically during its investment period. After the investment period, however, a fund’s unfunded capital commitments are diminished from making investments, and such fund then cannot make extensive use of a subscription credit facility due to lack of collateral. Funds in this stage still commonly have financing and liquidity needs as they manage their underlying portfolios, such as funding follow-on investments, obtaining letters of credit for portfolio companies, expenses and the general maintenance and liquidation costs for investments.
NAV financing can provide a solution for fund managers during this post-investment period. In contrast to a subscription credit facility collateralized by unfunded commitments, in a NAV loan arrangement a lender instead looks to the assets of the fund and the cash flows, distributions and other amounts received in connection with the fund’s assets as the main collateral for the loan. NAV loan arrangements can help to address the financing needs of mid-to-later-stage investment funds as they manage their portfolios and begin to harvest returns for investors. By pooling together a fund’s investment portfolio as the basis for credit, a manager can frequently obtain friendlier financing terms (particularly in a high interest rate environment) than if it attempted to solely raise debt at the portfolio company level.
Funds utilize NAV financing for a range of needs and goals, and the specific requirements and objectives vary depending on a fund’s strategy and the asset class involved. NAV financing is used by some funds to secure liquidity when other capital options are unfavorable. This may involve funding essential expenses like capital expenditures for leasing real estate development, making follow-on investments in existing portfolio companies, or covering ongoing maintenance and disposal costs. NAV loans may also be used to borrow against the total value of a fund’s portfolio to support struggling investments, such as curing a covenant breach within a portfolio company’s debt obligations. It is also increasingly common (though not without some controversy for some market participants) for funds to use NAV financing to add additional investments near the end of the fund’s term to enhance returns and performance, including by accelerating investor distributions. NAV financing can be an important tool for fund managers to extend the life cycle of a fund during periods where profitable fund exits are unavailable. Additionally, the challenging fundraising environment and higher interest rates in recent years have contributed to the increase in popularity of NAV financing arrangements. NAV financings are also used in other parts of the standard investment fund structure, including arrangements for general partners, portions of funds’ investment portfolios such as AIV structures, institutional investors and fund-of-funds.
Overview of a Standard NAV Loan Arrangement
NAV loans may take different forms based upon the structure of the fund and its investments, and the terms and structure of NAV financings are typically underwritten on a case-by-case basis. The arrangements, however, have some overlapping terms and usually share key structuring concerns. For example, NAV financings across asset classes are almost always long-dated agreements that use floating interest rates and compared to most middle-market direct lending arrangements the loan-to-value ratios are lower.
In addition, NAV loans typically use a borrowing base concept, such that the lender only provides financing to the extent of the value of the collateral, subject to certain eligibility and valuation criteria, which is then risk-adjusted for the lender by using an advance rate. As the fund’s investments fluctuate in value, the borrowing base under a NAV loan also fluctuates, thus increasing or decreasing the fund’s ability to draw down capital. The borrower (either the fund or a special purpose vehicle subsidiary of the fund) negotiates such eligibility and valuation criteria with the lender when securing a NAV loan, as well as the financial and reporting covenants that allow the lender to monitor the performance of the fund’s investment portfolio. Most funds that enter NAV loans have a mature portfolio of investments, so lenders can usually assess at the outset which investments should be included as “eligible investments” for purposes of underwriting a NAV loan. The underwriting processes for NAV loans vary widely by the type of fund that is borrowing under the loan – the lender’s diligence needs for a small portfolio of private equity control investments is understandably quite different than the diligence needs for a credit fund portfolio that could include hundreds of underlying loans – and thus the eventual credit terms for a private equity NAV loan and a credit fund NAV loan, for example, may (and often do) differ substantially.
Some lenders in certain asset classes (usually very high-performing buyout funds or infrastructure funds where the prospect of foreclosing on assets poses several legal and logistical challenges for a lender) will consider NAV loans on an unsecured basis. Mostly, however, NAV loan lenders prefer secured credit facilities and will take collateral in a few different ways. The collateral for NAV loans varies on a case-by-case basis, often depending on the nature of the investments the borrowing fund holds. In many NAV loans the collateral includes: (i) distributions and liquidation proceeds from the fund’s investments and the right to receive such amounts, (ii) a pledge of the bank account into which such distributions must be paid and (iii) a pledge of equity interests in any entity holding (directly or indirectly) the investments. The method of obtaining a security interest in cash distributions and liquidation proceeds is similar to that taken for traditional revolving credit facilities (including the subscription credit facilities).
Generally, a fund covenants to the lender that all cash from its investments will be directed into (or immediately deposited into if received directly) an account pledged to the lender and governed by an account control agreement. Likewise, the steps needed to secure the pledge of equity are similar to equity pledges common in the leveraged loan market. Whether the collateral package will include a pledge of equity interests depends on any restrictions on such pledges in the documents governing the underlying investments and on how practical it is to obtain any required consents to such pledges. If the borrower under a NAV facility is an intermediate holding vehicle rather than the fund itself, the lenders may also require that the fund provide a guarantee of repayment. Thus, in a workout scenario, the lender can foreclose on the equity interest collateral, and either take ownership control of the interests in the holding company or sell such equity interests and apply the foreclosure sale proceeds to its debt. Managers should be aware of such collateral requirements for NAV financings, as they impact the best way to structure and document fund offerings and portfolio investments.
Considerations for Managers
NAV financing arrangements can offer important flexibility and value to private fund managers across asset classes. Here are some of the most important considerations for managers to consider before pursuing NAV financing:
- Advanced Planning. While NAV financing arrangements are generally used in the later stages of the fund life cycle, the documentation and structuring concerns inherent in these transactions can be difficult to navigate if a fund manager has not given prior thought to using a NAV loan and planned accordingly. Managers should ensure that fund-level documentation and holding company- or investment-level documentation permit the use of NAV financings as broadly as possible, while adhering to the disclosure obligations and leverage limitations in their governing documents and those required by applicable law. This can be accomplished by seeking prior consents to the use of NAV financings or the related grants of security interests and pledges that may be needed from investors, other investment counterparties or portfolio company-level lenders and financing sources.
- Coordination. NAV financings can be complex, even for managers who view themselves as working in a relatively straightforward asset class with healthy portfolios. Having a fulsome understanding of a fund’s potential collateral structure, its underlying assets and related documentation and the fund-level document limitations is critical for facilitating a successful NAV financing transaction. Fund sponsors benefit from working with financing advisors and law firms capable of comprehensively handling a fund’s needs, including the fund formation and financing needs at each level of the fund structure and at each stage of the fund life cycle. Managers and advisors should work together closely to ensure that the terms of a NAV loan do not create problems for the manager, the manager’s fund (or other unrelated funds), the fund’s investors, or the fund’s portfolio companies and their affiliates.
- Transparency. A major concern for investors in private funds is the lack of market consensus on transparency around NAV financing arrangements. Managers should strive to provide as much information and transparency to investors as feasible (at a minimum, what is required by contract with their investors or by applicable securities laws), while seeking to realize the value that NAV financings are intended to provide for all parties involved.
Considerations for Investors
- Transparency. Because the use of NAV financing arrangements is arguably still in the nascent stages for the broader private investment funds industry, much of the market is still learning about the uses and terms of NAV loans in private funds. Fund partnership agreements have historically not specifically referred to these arrangements in the same way that they have subscription credit facilities, and in many cases the only parameters in the fund-level documentation available to investors are general restrictions on indebtedness. As a result, there are often no required disclosures to investors around the uses of NAV loans specifically. According to Neil Prunier, the senior director for industry affairs at the Institutional Limited Partners Association (ILPA) during a panel discussion at 2024 Fund Finance Association’s global symposium earlier this year, many investors are voicing concerns on this issue.
Prunier stated that the “vast majority” of institutional investors are not supportive of the use of NAV loans due to lack of transparency concerns. “Often,” Prunier continued, “[investors] find out about the use of a NAV-based facility after the fact and only through in-depth reading of disclosures and financial statements – not by being told up front and not by even being told after the fact.” ILPA plans to release guidance later this year for institutional investors, including investor education and basic transparency best practices for the use of NAV financings as one step toward alleviating these transparency concerns.
Finally, there may be a concern for investors (similar to one frequently voiced regarding the use of subscription credit facilities) that managers may use NAV loans to artificially enhance the internal rate of return (IRR) of their funds. This can be a conflict of interest if such return metrics are included in the calculation of the manager’s incentive fees. Investors should engage managers early in the investment process regarding the use of NAV financings and request that fund-level documentation such as partnership agreements or side letters include robust disclosure and reporting requirements around the use of NAV loans to facilitate better insights into the value and performance of their fund investments. Investors may also request notices of borrowings under NAV loans or limitations on managers’ ability to earn fees on outstanding portions of a NAV financing arrangements.
- Risk. Investors should clearly understand the risks that accompany a fund manager’s use of NAV financings (which are not wholly dissimilar from other uses of indebtedness). First, to the extent a fund may use leverage in its investment strategy at the portfolio-level, the introduction of a NAV loan facility at the fund-level can create two layers of leverage from an investor’s perspective. This “double leverage” situation can create a heightened risk of loss for the fund and its investors, as even a small diminution in value of the portfolio could create amplified losses for the fund.
Additionally, due to the portfolio-level underwriting and collateralization of NAV financings, investors may worry that managers are using the flexibility offered by credit facilities to continue supporting failing portfolio investments at the expense of high-performing investments. This kind of credit support between portfolio investments is one of the central tenets underlying the value proposition of NAV loans, but it can create situations where poorly performing investments act as a drag on a manager’s ability to focus attention and funding on investments capable of generating the best returns for investors.
Finally, investors should know in the event of insolvency at the fund level, the lender of a fund’s NAV loan will have a priority in payment over investors because it is senior to them in the capital structure, potentially resulting in realization of less value by investors in a fund, even if there are some assets of value in the underlying portfolio.
