Private Equity’s Biggest Leap of Faith Isn’t NAV Finance

Stephen Quinn Senior Managing Director, Investments

Trust is the lifeblood of private equity. For decades, investors have committed capital to blind pool funds, fully aware that they will have little control over what happens next. That trust has seen the private equity buyout industry grow to managing over $4 trillion of assets today.

When committing to a fund, investors accept a remarkable list of unknowns. These include which companies will be acquired, what price will be paid, how much leverage will be applied, and how long assets will be held. Yet they still invest and wait ten to fifteen years for the fund to run its course. That patience is not born out of naivety. It is grounded in rigorous diligence and careful selection, which allows investors to form a view on a manager’s skill, judgment and alignment.

That same trust extends to the tools managers use during a fund’s life. Over the years, the toolkit has expanded to include subscription facilities, dividend recaps, continuation vehicles, and more recently, Net Asset Value (NAV) finance. NAV loans are the latest to provoke debate.

As outlined in 17Capital’s report NAV Loans Uncovered, NAV finance allows well performing managers to borrow against the equity value of mature, diversified portfolios. The capital raised can fund follow-on investments, support add-on acquisitions, refinance debt, or provide interim liquidity to investors while retaining exposure to a fund’s strongest assets.

Some have argued that this adds a layer of leverage to an already levered model. But the timing matters. By the time NAV loans are put in place, typically in years 4-8 of the fund’s life, most portfolio companies have de-levered materially from their initial buyout. Leverage ratios are lower, cash flows are more predictable, and the businesses are more seasoned. In this context, borrowing modestly against the NAV of a portfolio does not introduce leverage beyond what managers and investors already accepted at the point of acquisition. In many cases it simply reintroduces capacity to deploy capital that the companies themselves have already paid down.

In other words, NAV loans do not represent a step-change in risk. They are closer to re-leveraging portfolios that have naturally de-levered since entry; and they do so at the fund level across a diversified set of assets rather than increasing pressure on a single company.

This is not to say transparency should be lacking. As the Institutional Limited Partners Association (ILPA) has suggested, managers should of course be open with investors about how they intend to use NAV finance and how it is applied. Not all fund documents are explicit, and in many cases NAV loans were not contemplated when investors originally committed, so clear disclosure and alignment are essential.

When that framework is in place, NAV loans are no more radical than the other decisions managers already make on investors’ behalf, such as which companies to buy, how much leverage to use, or when to exit. If investors trust managers with those choices, it is logical to trust them to apply the same discipline to their use of NAV finance.

Today’s market makes the debate especially relevant. Exit routes are constrained, hold periods are extending, and managers are tasked with funding value-creation plans for longer.

In this context, having access to a broader toolkit matters. NAV finance is not about changing the fundamentals of private equity, but about equipping managers with another option to create value, support portfolio companies and generate liquidity to crystalise value and increase IRR resilience when traditional routes are delayed.

For example, across the loans in 17Capital’s latest fund, the underlying portfolios were on average 78 percent invested at the time of execution. NAV loans gave managers the flexibility to pursue accretive add-ons and, in some cases, to initiate new platform investments. By enabling the funds to put a greater share of committed capital to work, in some cases up to 100 percent, they have helped reduce the gross-to-net spread and have generated additional value for investors.

Trust built private equity. It should also support its evolution.

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