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US leveraged finance: The road ahead
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Fund finance: Harnessing NAV finance in new ways

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HEADLINES

  • Anecdotal evidence points to a surge in uptake of net asset value finance over the past 12 to 18 months
  • NAV finance is useful for the prevailing longer PE holding periods, which climbed from 3.8 years in 2010 to 5.4 years in 2020
  • Deloitte estimates that the average loan-to-value ratios for NAV facilities sit in the 25% to 30% range

Demand for net asset value (NAV) finance—where private equity (PE) firms raise borrowings against the NAV of the assets in their funds—is on the rise. NAV finance is still a relatively esoteric, industry-specific product, and authoritative data tracking the market’s size and rate of expansion is scarce, but anecdotal evidence points to a surge in uptake over the past 12 to 18 months.

COVID-19 served as the catalyst for rising NAV finance demand, as managers explored alternative sources of cash. The need for additional liquidity came as exits were put on hold in the immediate aftermath of lockdowns, and managers moved to raise additional capital to see their portfolio companies through market volatility.

Even though capital markets and exit activity have now largely stabilized, PE appetite for NAV facilities is ongoing and the market has seen an influx of new lenders with NAV offerings to meet the new baseline of demand.

5.4
The average holding period in PE in 2020, up from 3.8 years
in 2010

 

Evolving NAV finance usage

As this uptake of NAV finance has increased, PE managers have begun exploring ways to use the product beyond servicing the immediate liquidity needs of portfolio companies.

NAV finance has proven especially helpful for managers that want to hold on to prized assets for longer. According to recent research from eFront, the alternative assets software group owned by BlackRock, average holding periods in PE climbed from 3.8 years in 2010 to 5.4 years in 2020.

The study also found that longer hold periods predict higher returns. According to the software group, on average, multiples on invested capital (gross of fees) came in at less than 2x for portfolio companies held for less than two years, but improved to around 2.5x after a five-year hold, and around 2.6x for deals held for between nine and 10 years.

NAV finance also allows managers to make distributions to their investors without having to sell crown jewel portfolio companies.

Investors stand to benefit too. Deloitte estimates that the average loan-to-value ratios for NAV facilities sit in the 25 percent to 30 percent range, so when used for limited partner (LP) distributions pre-exit, investors can receive a significant slice of value earlier in a hold period, which in turn enhances their internal rates of return.

 

Back-levering deals with NAV facilities

Managers are also starting to use NAV facilities to add in an additional layer of leverage to deals immediately following acquisitions.

Managers are effectively back-levering transactions at the fund level by putting NAV facilities in place as, or just after, the acquisition of a portfolio company closes. This means that, in addition to the borrowing done at the portfolio company level, the manager is also borrowing with NAV finance at the fund level.

The back-levered NAV facility has no direct credit support from the portfolio company but increases the leverage on the overall underlying transaction, as the sponsor is essentially financing part of their equity contribution.

For example, if a deal structure for a portfolio company requires a 40 percent equity contribution, the sponsor can pay for that equity contribution by only putting in 10 percent equity from the fund, with 30 percent coming from a loan facility up the chain on a back-levering basis.

General partner (GP)-led fund restructurings—where managers transfer assets held in an existing fund that is approaching the end of its term into a new vehicle—have also seen NAV facilities increasingly used in this way. Historically, fund restructurings would have been initiated by limited partner investors but, in recent years, GPs have proactively initiated restructuring deals to offer investors an opportunity to either roll their stakes over into a new vehicle set up by the GP, or take liquidity.

GP-led deals are typically funded by secondaries (investors who buy and sell fund stakes in PE funds). In a GP-led scenario, secondaries will buy out incumbent investors to facilitate the transfer of assets to a new vehicle, and then provide additional follow-on funding for the new fund structure. To ensure that they hit their return metrics, secondaries will often put an NAV facility in place to back-lever their equity commitments to the follow-on fund.

As the volume of GP-led deals increases (according to fund adviser Triago, GP-led deals accounted for the majority of secondaries deals for the first time in 2020) more deal flow is anticipated for NAV finance providers.

 

On the margin

Back-levered NAV loan structures have come to resemble those used for margin loans—interest-bearing loans that allow borrowers to lend against the value of securities they already own. What NAV lenders and borrowers are grappling with, however, is how to price the underlying assets in an NAV facility.

Margin loans are secured against liquid securities like equities or bonds, for which daily prices are quoted on public markets. In the event of default, the collateral securities can be sold easily on listed exchanges to reimburse lenders.

Privately owned assets that serve as security for NAV facilities, however, are usually illiquid and do not have easily identifiable reference securities that can be looked to for daily pricing. This poses interesting questions around how to track compliance with NAV facility loan-to-value ratios.

This is a developing area in the NAV finance space, as stakeholders determine how to use margin loan frameworks in a private market context. In some cases, borrowers and lenders will try to create a synthetic reference security linked to the listed bonds (if there are any) of the underlying portfolio companies. In other scenarios, lenders will require lower loan-to-value advance rates and higher pricing to account for the added risk.

There are no cookie-cutter solutions, with lenders and borrowers taking a bespoke, innovative approach in what is still a developing and rapidly changing market.

 

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US leveraged finance: The road ahead

 

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