In March, we discussed how net asset value loans are an effective and versatile tool for private investment fund managers, the use of which has ballooned in recent years. In response, the Institutional Limited Partners Association recently released guidance outlining best practices for both fund managers and LPs in approaching NAV loans. This post highlights key takeaways from ILPA’s guidance for consideration by fund investors and managers.
Potential Risks
While the ILPA guidance highlights a variety of beneficial use cases for NAV loans, it also warns they can create transparency issues for investors, and their wide-ranging applications may be worrisome to investors due to the relative novelty of their use in the market. IPLA notes that absent proactive disclosures regarding NAV loan-related strategy during the diligence process, investors may lack insight as to when and for what purposes they will be used. Of further concern to ILPA is because these loans are often used later in the life cycles of funds, many of the funds that can make the most use of NAV loans have governing documents that predate widespread use of the products. According to ILPA, this presents governance issues that can give fund managers an unchecked ability to use fund-level debt in ways the parties did not contemplate at the outset of the fund. Further, the ILPA guidance warns that some sponsors interpret existing fund-level leverage provisions to relieve any obligation to notify or engage investors or investor advisory committees regarding use of NAV loans.
ILPA also notes that increased use of NAV loans during difficult periods of fundraising may yield conflicts of interest for fund managers seeking to use NAV loans to boost the perceived return-generating performance of existing funds to buoy the capital-raising efforts for new funds. For investors with obligations to their own stakeholders, this dynamic increases the pressure to understand how and why fund managers are using NAV loans when reviewing performance metrics.
Finally, in addition to concerns about misleading performance indicators, the ILPA guidance discusses how NAV loans used to provide capital to a fund’s existing portfolio can introduce increased cross-collateralization risks. Accordingly, it advises investors to investigate where NAV loan proceeds are being spent at the portfolio level, as the fund-level leverage can create a drag on performance if proceeds are being used inappropriately to prop up poorly performing investments. The main remedy ILPA suggests for alleviating such investor concerns is more dialogue with fund managers as early as possible in the fund diligence process, which it thinks will give the greatest opportunity for the parties to enhance transparency around the use of NAV loans and provide investors the chance to introduce control-and-consent provisions as a check on sponsors’ ability to add fund-level indebtedness through collateralizing portfolio value.
Guidelines for Enhancing Transparency, Disclosure, and Engagement
The ILPA guidance recommends addressing investor concerns by improving transparency and engagement. To achieve this, ILPA recommends LPs and managers engage with each other at varying levels, depending on the intended use of NAV loans and whether the applicable governing documents explicitly address NAV loans. If an existing governing document is silent or otherwise lacks adequate coverage on NAV loans specifically, ILPA recommends investors discuss their interpretations of existing provisions regarding indebtedness with fund managers. ILPA further recommends that fund managers seek investor advisory committee consent before using a NAV loan as a best practice and to improve investor relations. ILPA also encourages investors to check in with managers periodically on the pre-existing or contemplated uses of NAV loans or similar products. Depending on the context of the NAV loan, these discussions could include topics such as:
• The rationale and intended use of proceeds of the loan;
• Alternative methods of financing considered;
• The size of the loan, including amounts drawn at closing and amounts available to be drawn later;
• Use of special-purpose vehicles;
• Subordination;
• Cross-collateralization;
• Repayment requirements;
• Key covenants;
• Whether the facility is secured or unsecured;
• Cost of capital;
• Any LP obligations in connection with the debt documentation; and
• Conflicts of interest.
ILPA’s guidance splits the preferred approach for managers when contemplating the use of NAV loans. If the loan is to be used to generate early distributions, ILPA suggests that managers should first receive investor advisory committee approval and explain to investors why a NAV loan is the best financing option, how the loan will maximize returns and how it will avoid risk. For NAV loans intended to support the portfolio, ILPA believes that if the manager already has an investor advisory committee consent or governing document provision permitting the use of a NAV loan, such manager need not return to the investor advisory committee for consent to use the loan to support the portfolio, since these circumstances generally follow the use case of traditional portfolio-level leverage. However, ILPA recommends that a manager with consent to use a NAV loan should still disclose to all investors that one is being used to support the portfolio and the reasoning behind the loan, particularly given investors’ concerns around cross-collateralization of strongly and poorly performing fund assets.
Accounting for NAV Loans in New Governing Documents
ILPA’s guidance offers approaches to legal documentation relating to the use of NAV loans, starting with a recommendation that they should be explicitly addressed in the governing document of each fund to provide clarity of use cases, scope and size of the loan and transparency for investors. ILPA recommends such definitions capture traditional borrowing arrangements, preferred equity financings and various structures that might allow for borrowing under the NAV loan to occur at a subsidiary or other special purpose vehicle of a fund. In this regard, ILPA suggests that such definitions provide that the collateral of the loan are the fund’s assets and proceeds thereof (such as distributable amounts).
ILPA also asserts that governing documents should set expectations as to the scope of NAV loans and distinguish permissible uses. According to ILPA, related provisions should clarify under what circumstances fund management must engage or receive approvals or consents from investors around the varying uses of NAV loans. Perhaps most importantly, ILPA recommends that this language establish a limit on the amount of leverage that may be incurred through NAV loans during the life of the fund — though the guidelines do not go so far as to recommend a specific percentage threshold.
Finally, the ILPA guidance emphasizes the need for NAV loan reporting requirements to be written into new governing documents. In ILPA’s model partnership agreement, the general partner must report to each limited partner several metrics, including the amount of debt encumbering the fund generally, the amount of debt encumbering any specific portfolio investment, the extent of any cross-collateralization and details of each credit facility in use by the fund.
