NAV lending: a solution for liquidity and mid-life private equity funds?

Executive Summary

  • The coronavirus pandemic accelerated existing trends of liquidity gaps in private equity driven by longer hold times and greater capital needs for “buy-and-build” strategies
  • NAV lending seeks to solve these issues by providing efficient growth capital and defensive liquidity at a time when capital is most constrained
  • NAV lending is becoming more of a mainstay in the fund-financing world

NAV lending: another tool to address liquidity needs in private equity

In response to the coronavirus pandemic, lenders have become more risk-averse with their balance sheets. Additionally, many older private equity funds have used their remaining investable capital to defend the value of portfolio companies. This, coupled with market factors that predated the pandemic, have left many private equity funds and their portfolio companies with limited liquidity to continue funding buy-and-build strategies, which require more capital as investment hold periods increase.

Enter NAV lending. This type of fund financing existed pre-pandemic, but stands in the spotlight against the current market backdrop. NAV facilities can support specific investments in a fund, backed by the NAV of the whole fund, or can be lent to the fund as a whole. The benefit of applying NAV lending to a private equity portfolio is to fill liquidity gaps. This allows the funds to defend or enhance the value of their portfolio companies without diluting their ownership.  Hold periods in private equity have increased, from a low of approximately three years before the 2008 Global Financial Crisis, to current levels of four and a half to six years. This has made the importance of addressing the “liquidity gap” with creative financial solutions more pronounced.

Chart 1: U.S. MM PE median years to exit by fund size

Source: ASI, Pitchbook  Q2 PE Breakdown,* June 30, 2020

Covid-induced market volatility was a stark reminder of the fact that even promising, growing investments could collapse if they run out of money. And if these investments run out of money, it doesn’t matter how much potential upside they might have had. Newfound attention on NAV lending is not just a result of the pandemic. It’s also part of a natural progression toward seeking liquidity — a trend we expect to continue throughout 2021 and beyond.

NAV lending is becoming more mainstream as GPs are beginning to see how it may also help finance “tack-on acquisitions” effectively. However, one downside to the buy-and-build strategy is that it requires greater amounts of capital throughout the entire life of the investment, as opposed to a single investment at inception.  In the past, fund managers have foregone accretive add-on opportunities or financed them with dilutive capital when investable capital is limited.  Financing an add-on with an NAV loan allows private equity funds to grow the value of their portfolio without dilution.

Chart 2: Add-ons are a part of the strategy

Source: ASI,  Pitchbook, Q2 PE Breakdown, *September 30, 2020

A solution for funds in middle age

“Middle-aged” funds, in particular, highlight this trend toward seeking liquidity. Younger funds are still in their investment periods, so they typically have investable capital from LP commitments and they can get capital call lines from banks fairly easily. End-of-life funds (funds older than 10 years) have little diversity left because only a few companies remain in the portfolio. Often, these companies are also the most challenged ones. Middle-aged funds are in a crucial period to create value for their investors and are therefore ideal candidates for NAV lending. They are typically out of their investment periods, and lack easy financing alternatives, but are still diverse enough to lend against safely.

Chart 3: Filling the gap for “middle-aged” funds

Source: ASI, February 10, 2021. For illustrative purposes only.

Before the pandemic, some private markets participants viewed this type of private-credit investing as esoteric. NAV lending may even have looked, to some managers, like a last-ditch option to revive fund liquidity. However, in the early days of the pandemic, when liquidity demand spiked, NAV lending began to look more attractive. Managers began to realize that it aligns GP and LP goals to support portfolios and seek to maximize returns for LPs. Now it may be easier to see that, philosophically, NAV lending is not so different from committing more equity to support a portfolio company. It is another way to support a company that managers believe in, but it can be less costly and more efficient than committing more equity.

Investment diversification and income enhancement

In a an era of low interest rates and the search for yield within fixed income allocations, institutional and retail investors have begun to migrate from public to private markets to achieve a higher threshold for performance and diversification, albeit with less liquidity. The result of this shift has been a greater emphasis on growth in the private debt and equity space. As an asset class, direct lending has matured and now provides differentiated characteristics that are advantageous to a yield-oriented investor. As a subset of the direct-lending family, NAV loans have unique covenant and recourse features that result in high-quality loans that fit well within an investment-grade framework. 

Therefore, income-centric investors, especially insurance companies, may find that NAV loans satisfy many of their requirements. Since the predominance of the loans tend to be investment grade, the risk-based-capital charges are less onerous, the income generation tends to be higher than traditional middle market loans, and there has been a scarcity of defaults through multiple market events. 

Insurance companies, in particular, have found that this strategy fits well within their private-credit allocations, while also creating an elegant solution for the end borrowers.  

Conclusion

Covid-19 has given NAV lending a tailwind, but ultimately, NAV lending can help plug the liquidity gaps in older funds, pandemic or not. In general, firms have paid high multiples for the companies in their portfolios. In order to generate the returns GPs and LPs expect managers may need to put more elbow grease into their portfolios for longer periods of time.

In our view, NAV lending is morphing into a mainstay in the fund-financing world. The pandemic has given managers a reason to consider NAV loans, but, in our view, this change was always coming. Liquidity tends to find the places that aren’t liquid over time; NAV lending is part of a natural evolution. Middle-aged funds are going to continue to exist and present liquidity challenges, and growth opportunities, to managers. We believe that in the years ahead, NAV lending will become an increasingly prominent solution. 

By Doug Cruikshank

IMPORTANT INFORMATION

Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

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