Net Asset Value (NAV)-based financing facilities (“NAV Facilities”) continue to proliferate in private equity. In response, the Institutional Limited Partners Association (ILPA) released comprehensive new guidance making the case for transparency, governance, and risk management to be fundamental considerations in the incurrence and deployment of NAV Facilities. Since the onset of the COVID pandemic, NAV Facilities have gained traction among private equity strategies as a source of liquidity and an additional resource for General Partners (“GPs”) to manage indebtedness, support portfolio companies, or make early distributions to Limited Partners (“LPs”).

However, this growing reliance on NAV Facilities raises significant concerns for the LP community, particularly in light of limited transparency and explicit governance within many existing Limited Partnership Agreements (“LPAs”).

In an effort to promote a more balanced and informed relationship between GPs and LPs, ILPA’s guidance seeks to address these issues by outlining best practices for the use, disclosure, and documentation of NAV Facilities.

This alert provides an overview of the key recommendations and considerations from ILPA’s guidance, emphasizing the need for proactive engagement and legal clarity in the incurrence and deployment of NAV Facilities within private equity funds.

Key Takeaways:

1. Growing Prevalence and Market Impact: The use of NAV Facilities is expanding, with the market projected to grow from $100 billion to $600 billion by 2030. These facilities, secured by the underlying value of fund investments, are used to manage liquidity, support portfolio companies, or provide early distributions to investors.
2. Transparency and Disclosure: ILPA emphasizes the need for greater transparency from General Partners. The guidance recommends that Limited Partners be informed about the use of NAV-based facilities, including their terms, costs, proposed use cases, LP obligations, and associated risks. This is crucial for LPs to assess the impact on fund performance and to make informed decisions.
3. Synthetic Performance: ILPA identifies the perverse incentives for a GP to use NAV-based facilities to fund performance (namely internal rate of return (“IRR”) and distributions to paid-in capital (“DPI”) calculations) which can be synthetically improved by the liquidity generated through NAV Facilities. ILPA notes that distributions from NAV Facilities are often recallable, creating an environment which could result in LPs paying for the interest expense of a NAV Facility which is later recalled.
4. Governance and Legal Considerations: ILPA urges GPs to seek explicit consent from LP Advisory Committees (“LPACs”) before implementing NAV Facilities, particularly when the proceeds of a NAV Facility will be used to generate DPI. The guidance also advocates for updated legal documentation in Limited Partnership Agreements to set clear boundaries on the permissible use of NAV Facilities.
5. Recommended Practices: GPs are encouraged to engage proactively with LPs, disclosing the rationale, size, structure, and economic terms of any NAV facilities. The guidance also suggests that NAV facilities should be considered fund-level leverage and included within borrowing limitations. Importantly, ILPA has provided template Q&A forms for this purpose as well as suggested questions to be proposed by LPs.

This updated guidance aims to foster a more transparent and collaborative approach between GPs and LPs, ensuring that the use of NAV Facilities aligns with the best interests of all parties involved. While innovation in private investment funds is a natural byproduct of the evolving market and industry (and hopefully used to generate improved LP returns), NAV Facilities present a unique set of challenges in light of their impact on a fund’s risk profile. Their potential use for a variety of reasons may be viewed by LPs as welcome and accretive additions to the fund’s investment program, while others may view them otherwise.

Whether or not LPs are in favor of or neutral to NAV Facilities, best practices dictate that LPs at least be aware of the issue so they can make informed decisions when proceeding through the legal diligence process with a fund manager.