During the past several years, turbulence in financial markets—stemming first from COVID-19 and then from the changing interest cycle—has caused fund sponsors to face both heightened liquidity needs and a slowdown in private equity exits. In response to these conditions, we are seeing considerable growth in the use of net asset value (NAV) financing by fund sponsors as a means of meeting additional liquidity needs and as an alternative to traditional exits. Below are some of the key considerations when putting in place NAV credit facilities.
Given that NAV financing is a relatively new tool in private equity, determining whether a NAV credit facility is permitted under the fund’s limited partnership agreement (LPA) is often an important first step—particularly for later-stage funds with legacy form LPAs. However, we are now seeing a newer vintage of LPAs that specifically anticipate and build in mechanics for the use of NAV financing. With this development, we are seeing sponsors turn their focus towards providing investors disclosures and discussions regarding anticipated leverage at an earlier stage in the fundraising process.
In the United States, the borrowers under NAV credit facilities typically consist of one or more bankruptcy-remote special purposes vehicles (SPVs) that are joint and severally liable. Those SPV borrowers will usually hold 100% of the equity interests in investment vehicles that in turn will hold the portfolio companies of the fund. If tax or other considerations restrict transfer to the SPVs, the NAV financing may be structured by having the borrowers hold a preferred interest in the cash streams from the relevant portfolio assets instead of holding the portfolio assets themselves. However, such “off to the side” structures are mainly prevalent in Europe rather than in the United States.
Diligence is always an important focus for lenders and spans both the upper-tier and asset levels. At the upper-tier level, diligence typically focuses on the structures for how investment vehicles are held, how lenders will in practice have recourse in the event they need to take enforcement action and ensuring that borrowers are sufficiently remote and limited in the scope of actions they can take (that is, that the SPVs are in fact, truly bankruptcy remote). At the asset level, diligence review can be broad ranging and take some time to complete. Typically, diligence will cover everything from the composition of the portfolio (which will feed into concentration limits included in eligibility criteria) to ensuring that appropriate steps have been taken to allow lenders to enforce against assets (e.g., obtaining any third-party consents required for transfer or assignment of assets).
Unlike the “all assets” pledge that is common in more traditional areas of secured lending, collateral packages in the NAV financing space often vary. For example, lenders typically do not have direct recourse to the portfolio assets of the underlying funds. Instead, it is more common for lenders to only have recourse to the assets of the SPV borrower (which typically consist of bank accounts and the SPV’s right to receive cash distributions from the portfolio assets). In such cases, lenders may also seek a pledge of the SPV’s and/or the investment vehicle’s equity interests. However, this is typically subject to diligence (as to, for example, whether such equity pledges are restricted by the entities’ constitutional documents). Depending on the structure, “bad acts” guarantees are commonly provided by parent funds to provide lenders with additional protection. Unlike a full parent guarantee, such guarantees will typically only protect against a limited range of more serious acts (e.g., against borrowers transferring assets to entities not subject to the collateral package or putting in place a pledge over assets in favor of other creditors) and bankruptcy events.
While the fund’s quarterly report is the starting point of the valuation, the right to challenge such valuations and receive third party appraisals is often an important focus for lenders under NAV facilities. Negotiation here typically centers on the scope of appraisal rights and how often those rights can be exercised (including whether the occurrence of certain key events should trigger additional rights). Depending on the complexity of the appraisal rights, which party will bear the cost of such appraisal can also be an important factor. In some cases, parties will set out criteria for making that determination, such as whether an event of default is ongoing or how many lender-initiated appraisals have already occurred in the calendar year.
Consistent with other areas of asset-based lending, eligibility criteria are used under NAV facilities in determining which assets will qualify for inclusion in the borrowing base and ultimately serve as an important mechanism for lenders to mitigate their exposure to the risk of performance associated with the underlying assets. While it is common for portfolio assets subject to bankruptcy or payment events of default to be excluded from eligibility, other terms may be more heavily negotiated. For example, borrowers may try to limit certain other exclusions to only those resulting in a specified decline in the applicable asset price.
Cash sweep mechanisms in NAV facilities vary broadly and are usually heavily negotiated, given that lenders primarily only have recourse to cash distributions from the portfolio companies. The agreed-to mechanism will typically net out a limited number of items, such as tax distributions, before funds are applied as per the cash sweep. Often the cash sweep is limited in the earlier years of the facility so long as loan-to-value is below agreed thresholds. Over time, depending on the performance of the fund and the number of assets in the portfolio, all netted proceeds may need to be swept to pay down the loans.
Depending on the nature of the collateral provided, options for enforcement may take different forms. Typically, lenders will have a right to require that the borrower commence a sale process in the event of certain material defaults, such as when a borrower fails to make a mandatory prepayment and concurrently fails to comply with an LTV maintenance covenant. In such cases, the sponsor will usually retain control over the sale process, provided that the sponsor parties keep lenders informed and comply with timelines and procedures set out in the NAV facility. If the sponsor fails to meet such requirements or in the case of certain negotiated events of default, the lenders may have the ability to direct the sale process.
As more alternate lenders enter this market, in the current interest rate environment, we expect NAV financings to continue to rise in popularity and become a standard component of the fund finance toolkit.
The Private Equity Report Fall 2023, Vol 23, No 3