A confluence of factors has led to a constrained capital and liquidity environment for GPs and LPs. For one, the exit market largely remains shut, with global private equity exit volume dropping to $591.8 billion in Q3 2023, marking a stark decline from the peak of $1.8 trillion in 2021. As a result, capital supplies from fundraising have contracted, resulting in a tight liquidity environment.
Additionally, as dislocated bid-ask spreads continue to extend hold periods, many GPs are in situations where their funds are fully deployed. Yet, financing is needed to sustain longer growth trajectories. However, elevated interest rates throughout 2023 have significantly increased the costs of asset-level financing. With traditional lenders tightening their purse strings, GPs have been forced to pursue creative financing structures.
As a result, net asset value (NAV) loans — fund-level loans underwritten against investment portfolios — have emerged as a useful direct lending product for this environment. While firms like 17Capital and others have been offering this financing since the late 2000s, the popularity of the lending type has exploded recently. NAV loan deal flow activity has grown 30-50% annually in recent years, with a record volume of over $35 billion during the first nine months of 2023.
With managers looking to finance growth initiatives for portfolio companies, refinance leverage at manageable rates, and generate liquidity for investors, these loans have provided a less expensive facility than traditional lending options due to the diversified nature of the collateral.
A NAV credit facility is a financing arrangement where a lender extends credit to a fund, with the loan secured by the NAV of the fund’s investment portfolio. Private equity funds typically employ these vehicles during the post-investment period, as funds can no longer tap subscription-backed credit facilities, a popular tool for funding cash needs. While NAV terms vary by transaction, they broadly share several characteristics:
Private equity fund managers are using NAV loans to serve a variety of purposes for their portfolio companies and investors. However, the most widely tapped use cases include acquisition financing, capital infusion, or accelerating distributions to LPs.
Navigating price agreements amid recent valuation fluctuations has made selling assets more challenging. Buyers and sellers are finding it harder to reach a consensus, leading managers to extend the holding period for assets beyond initial timelines. Therefore, GPs are managing portfolio companies deeper into their harvest periods when there is less access to equity capital through their LPs’ unfunded commitments.
As a result, an increased demand for M&A financing has surfaced. Yet, the scarcity of available investor capital and the limited ability of many platform companies to take on additional debt for expansion have challenged PE managers’ ability to capitalize on value-add acquisitions.
Amid these dynamics, NAV loans have provided a cost-effective solution for managers to fund M&A pipelines. Moreover, opting for these facilities enables fund managers to smooth capital pacing and deploy cash more efficiently, alleviating administrative burdens on LPs at a time when many are contending with their own liquidity constraints.
The lower cost of NAV financing, coupled with the enhanced flexibility it offers in timing exits, has attracted investors seeking capital support for companies in the later stages of their fund lifecycles. Many fund managers have tapped NAV loans as a source of bridge financing for strong portfolio companies experiencing temporary stress from higher interest rates, using proceeds to strengthen balance sheets and maintain comfortable cash levels without selling and foregoing upside.
Further, as a wave of debt maturities from heightened M&A activity in 2021 nears — totaling $700 billion through 2026 and nearly $2 trillion through 2028 — many managers are looking to de-risk their portfolios. However, higher interest rates coupled with stagnated earnings mean many companies have underperformed projections from when they originally secured financing. As a result, most lenders will only lend at substantially lower leverage compared to 18 months ago. In turn, many GPs are using NAV loans to de-lever and complete portfolio company refinancing at more attractive pricing.
Private equity investors have endured a prolonged lack of exit opportunities, with distributions as a percentage of NAV hitting a decade-low — standing at 13.1% of initial NAV in Q2 2023. Yet, keeping pace with recent distribution rates would likely force managers to part with their top-tier companies.
As investors seek cash, GPs can use NAV loans to provide liquidity to LPs while retaining potential upside until market conditions improve. This is especially useful for LPs who are overallocated to private equity and need distributions to fund future commitments but don’t want to realize discounted returns by selling their investments on the secondary market.
While NAV loans have played a pivotal role amid current market dynamics in supporting valuable initiatives for fund managers and, in turn, LPs, they fundamentally reshape the economic profile of a fund. Therefore, it’s crucial for allocators to comprehend the risk-return attributes of these loans in various scenarios across their funds, with technology offering a valuable tool for efficient visibility into fund-level debt and overall asset quality.
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