Investors’ adoption of NAV loans to address capital and liquidity needs has stirred mixed feelings among allocators, reminiscent of prior uncertainty surrounding the use of subscription lines — many advocates argue NAV loans need to go through a similar ‘growing up phase.’
On one hand, a distinct liquidity and capital gap exists, with NAV loans uniquely addressing this need among current market dynamics compared to alternative financing options. Many fund managers have a strong underlying rationale for deploying these loans to support a number of value-add use cases, such as funding M&A pipelines.
However, while NAV loans offer a versatile tool for achieving a wide range of investment objectives, they also introduce several risks and considerations for LPs. Unsurprisingly, taking on an additional layer of debt amid rising interest rates and using borrowed funds to accelerate distributions has raised eyebrows.
Further, as with any debt product, a NAV loan’s terms and covenants significantly influence its potential impact on a portfolio (e.g. cash flow sweep negotiations, LTV trigger buffers, and PIK interest options) Ultimately, a comprehensive analysis is required to evaluate the use and impact of these facilities. Below, we examine a few important NAV loan considerations LPs must keep top of mind.
NAV loans are primarily floating rate instruments. With rising interest rates, NAV loan borrowing rates have surpassed the 8 percent hurdle rate for fund performance, raising questions about the viability of their economics — applying another layer of leverage on the portfolio at a 12-15% rate amplifies leverage risk concerns. Further, excessive leverage at both the portfolio company level and the fund level can restrict portfolio company growth, impacting fund performance.
This said, increasing financing costs don’t diminish a GP’s conviction on an add-on or other value creation opportunity with clear return visibility in the long term. Moreover, while heightened NAV loan costs are a critical consideration for LPs to diligence, evaluating the cost of capital beyond NAV financing holds equal significance. In many cases, these facilities currently provide the lowest cost of capital. The major concern with escalating costs emerges when these loans act as bailout capital to reduce the leverage of a company saddled with costly company-level debt, lacking a clear path to recovery or exit.
Inflated fund returns have also been a point of concern for LPs, as NAV loans improve IRRs, which are used to determine managers’ incentive fees. Artificial DPI has also raised questions. However, while GPs have tapped NAV loans to fund distributions, it’s not a one-way street. LPs want cash, and NAV financings can deliver this without forcing them to sell investments on the secondaries market, potentially at a notable discount.
Already, LPs have started factoring in or discounting certain NAV loan-enabled distributions. A survey from Capstone Partners revealed that, among North American LPs, 80% of those LPs only give partial credit to GPs for these “synthetic” distributions, and 14% don’t give any credit at all.
NAV loan leverage marks a fundamental departure from the traditional PE playbook. While fund-level facility pricing is typically more economical than borrowing at the company level, the reduced spread comes with the trade-off of cross-collateralization.
Theoretically, a diversified portfolio can absorb fluctuations in the value of individual investments if others generate enough value to offset losses. However, one of the traditional allures of private equity lies in the absence of debt cross-collateralization among portfolio companies. Traditionally, a credit issue at one portfolio company would not impact other companies in a fund. NAV loans counteract this benefit. In the end, a low LTV is not a concern until it becomes one.
In short, NAV loans can be additive or dilutive vehicles, largely depending on the underlying rationale for deployment and the terms of each transaction. Refinancing debt through a NAV loan — as exemplified by Vista’s recent Finastra transaction — can sometimes offer the most cost-effective means to enhance the capital structure of heavily indebted companies with imminent debt maturities.
Ultimately, NAV loan risks are best mitigated when the collateralized fund comprises a robust asset base of high-quality, performing companies. Enhanced visibility into funds and their underlying assets empowers LPs with insights crucial for facilitating informed discussions with GPs on NAV and other fund-level financing and how they impact the overall risk and return profile of their funds.
With visibility into the quality of underlying assets of a fund and leverage exposure at a portfolio and company level, LPs can conduct insightful risk analysis into the impact of NAV loans on fund performance. Yet, for most, these insights are buried in the finer details of fund financial statements, which may not receive as much attention as quarterly reports. Additionally, inconsistencies in how different GPs report fund-level debt make it challenging to yield a centralized, harmonized understanding of a fund, manager, or portfolio’s fund-level financing circumstances.
Chronograph addresses this issue by capturing complete fund financial statement balance sheets directly from source documentation and allowing LPs to apply a harmonization layer to all reported metrics. As a result, Chronograph provides LPs with clarity into fund-level financing, empowering them to assess the uses and consequences of these strategies within their portfolio.
Moreover, Chronograph provides seamless access to all reported metrics for underlying portfolio companies within a fund, allowing LPs to enhance their understanding of the quality of assets collateralized by the loan and particular debt-related risks in the portfolio.
Request a demo to learn how LPs can use Chronograph to navigate fund-level financing and understand underlying asset quality across their funds.
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