Until recently, net asset value (NAV) finance—where PE sponsors borrow against the NAV of the companies in their funds—occupied the fringes of the financing mainstream.
The impact of COVID-19 lockdowns on M&A activity, however, thrust NAV finance into the spotlight, as managers sought alternate sources of liquidity.
As the NAV finance market is still nascent, data on its size and growth is scarce, but anecdotal reports from advisers, funds and banks that provide NAV facilities indicate that activity and deal flow hit record levels in 2020.
Volatile valuations and the fall in exit activity during the pandemic spurred uptake and interest in NAV finance options. According to BlackRock-owned alternative assets software platform eFront, global total value to paid-in (TVPI) investment multiples for active PE funds fell from a near record 1.45x at the end of 2019 to 1.36x in Q1 2020, dropping to levels last seen in 2014.
As multiples have fallen, PE firms have been reluctant to crystallize drops in valuations by selling. Global private equity exit value for the year to the end of Q3 2020 is down 11% year on year, with exit volumes over the same period falling 26%. The drop in exit activity has meant that PE firms have been unable to realize value when selling assets and making distributions to investors.
NAV financing options, however, allow firms an alternate way to access capital by borrowing against the NAV of portfolio assets. In addition to making distributions to investors, financial sponsors have used the cash to help portfolios see out COVID-19 disruption, or fund follow-on acquisitions and operations when fund investment periods have closed or when funds are fully called and can no longer draw down capital from investors.
Although PE hold periods shortened in 2019, according to PitchBook, hold periods could lengthen again this year and into 2021 as managers wait for asset pricing to recover. As hold periods lengthen, more managers are likely to consider NAV financing as an option.
In the evolving NAV financing market, the pricing, terms and structures of facilities are bespoke and flexible. Generally, however, NAV financing will be structured as a term loan, rather than a revolver, and price at between 500 and 1000 basis points over LIBOR, depending on the nature, quality and concentration of the underlying assets. In terms of the debt quantum that sponsors are able to secure from NAV loans, loan-to-value (LTV) ratios will typically sit in the 25% to 35% range for PE and secondary sponsors but can be substantially higher for credit funds.
Financial sponsors using NAV facilities will typically structure an aggregator vehicle, which serves as the borrower for the purposes of the NAV facility. Portfolio assets are then transferred beneath these aggregator vehicles in order to borrow against them. Sponsors can choose to do an NAV loan over an entire portfolio or only borrow against a subset of the businesses in their funds. Managers will transfer selected assets into the NAV structure accordingly.
NAV finance lenders are first in line to be paid back from the assets in the NAV facility. When agreed LTV ratios are exceeded, loan agreements will grant lenders a cash sweep over the assets. This sees lenders automatically receive any excess cash from companies in the NAV structure before payments or distributions can be made to investors.
Although investors can benefit from NAV financing when it facilitates distributions, some have voiced concerns that the additional leverage taken on through NAV facilities can shift risk thresholds beyond original estimates or expectations. In the latest iteration of the Institutional Limited Partners Association Principles, published at the end of 2019, the investor industry body recommended enhanced reporting on the use of fund finance and for NAV finance to be included in the context of the overall leverage limitations on a fund.
It also remains to be seen how NAV facilities will unwind in the event of distress, as cases of defaults have been rare. Lenders do have first option on the equity of the underlying portfolio companies should a financial sponsor default, but taking control of the equity positions in companies may not be straightforward.
For example, while enforcement over a portfolio of credit interests may be relatively simple, lenders to a PE portfolio likely will find it difficult and potentially value-destroying to enforce if doing so would cause change of control defaults with respect to the debt of underlying operating companies. In addition, a change of control of assets in certain sectors, like energy and financial services, can also trigger a regulatory consent requirement, which adds a further layer of complexity.
As a consequence, the remedies provisions of NAV facilities often attempt to avoid this scenario by setting an LTV threshold above which the sponsor is required to deliver a plan to cure the LTV breach within a specified amount of time (sometimes six to nine months) but which do not permit enforcement by the lender so long as the plan is completed successfully. Immediate repayment is required—and enforcement of the security permitted—only if the plan fails to be presented in a timely fashion, fails to be completed successfully by its deadline or if an even higher LTV threshold is breached in the interim.
In assessing the credit and default/recovery risk of a particular loan, NAV lenders are typically not taking a position exclusively on the underlying assets in a facility, but also on the manager taking the loan.
Lenders will recognize that sponsors will be eager to avoid an NAV-loan default, and that LTVs are set at a level that provides a large equity cushion in front of the lender’s capital. Sponsors have to repay NAV facilities before they can extract remaining equity from portfolios, and so their incentive is to ensure the NAV lender is repaid so that the remaining capital can be preserved and returned to their investors.