Silver linings from the pandemic seem oxymoronic, but there is one area of private debt that appears to have benefited from the virus: net asset value loans.

Part of the larger and growing area of fund finance, NAV loans, which are backed by the consolidated equity value of a fund’s portfolio, are typically made to a vehicle to enable it to meet cash needs, including providing limited partners with a full or partial exit. Long a niche product, the loans started to move into the mainstream during the early days of the pandemic, when financing wasn’t always easy to obtain.

“Covid was an accelerant for awareness of NAV financing,” says Greg Hardiman, an investment director of 17Capital, a pioneer in preferred equity and NAV lending. Since its founding during the global financial crisis, the London-based manager, with $11 billion of assets, has made 91 investments and seen 46 exits, and has “never lost money”, according to co-founder and managing partner, Pierre-Antoine de Selancy. Being very choosy doesn’t hurt, with de Selancy noting that the firm invests in just 10 to 20 deals of the 200 opportunities it sees each year. 

Indeed, 17Capital, in which Oaktree took a majority stake last year, is seeing strong investor demand for its own funds. It is currently investing out of its fifth preferred equity fund, which closed at $2.9 billion in June 2021, and its debut credit fund, which closed at €2.6 billion in April 2022. 

17Capital predicts the strategy will grow sevenfold by 2030 from approximately $100 billion today. Already last year, Hardiman says the firm “observed 50 percent growth” in NAV financings, with well over $30 billion of dealflow in 2022. “Investors in private equity are aware that NAV financing solutions exist and are appreciative of their value in helping them unlock the value of their portfolios,” Hardiman says. 

“Fund finance is a huge and growing area,” says Jasen Yang, a managing director in structured credit at fund manager Apollo. 

Yang explains that fund finance encompasses a range of strategies, including more conservative NAV loans, where Apollo tends to focus, and preferred equity, a form of financing often made towards the end of a fund’s life when there are only a few remaining assets the GP may not be ready to sell. 

True NAV loans are typically investment grade and longer dated, with low loan to value. By contrast, preferred equity fund financings, which aren’t true loans and lack the same security interest in assets, tend to come in the later/harvesting phase of a fund lifecycle.

Change in mindset 

NAV loans have been expanding so rapidly because “there has been a change in mindset”, says Yang, and their increasing appearance in fund documents is a measure of their acceptance. He likens awareness of NAV loans to that of subscription lines five years ago. 

“Once people start seeing them, they become more socially acceptable,” Yang says. He believes the NAV phenomenon is evidence of the growing professionalism of GPs as they more artfully manage return and call of capital. “Sponsors may be great at running companies, but now they’re realising that their fund capital structures are also something to manage and they can take some debt there that can be accretive to LPs.”  

With fundraising in alternatives growing exponentially over the past few years, “by default subscription capital grew with that, as did later-stage NAV financing when subscription lines are no longer available”, says Mark Doctoroff, managing director and global co-head of the financial institutions group at Mitsubishi UFJ Financial Group. 

Historically, fund finance “has been a means of expanding AUM and improving and optimising IRRs”, says Erik Miller, a partner at Canyon Partners. But in periods of tightened liquidity, such as occurred in the UK during the liability-driven insurance debacle, there may be issues if there’s a margin call on repo financing when the underlying collateral drops in value. 

Nevertheless, although NAV loans are bespoke, and it can be difficult to assess the overall leverage of the fund, “the downside risk is low”, says Doctoroff.

The loans, which are senior and tend to be floating rate, aren’t being made to the portfolio companies, but against their value. They have a maturity date, but it’s generally lengthy and lenders expect the assets will be monetised before maturity when they are sold. 

Due diligence key 

Moreover, Hardiman of 17Capital notes that larger managers are increasingly using the loans, helping the firm to align itself with franchise value. Manager and portfolio due diligence, as well as good governance of the borrowers, are important factors in the decision-making process, de Selancy says.

Nayef Perry, global co-head of direct credit at investment manager Hamilton Lane, says many of the loans are floating rate, so yields increase along with rates. If a GP defaults, “the NAV lender sits on top of the cashflow waterfall”, Perry says. “As funds experience a liquidity event, there’s a cashflow sweep mechanism that allows the loans to get repaid before distributions are sent to investors.” 

NAV loans are typically made against a small portion of the portfolio, so in the event of a workout, lenders are able to recover loan values when the assets are sold, unless most of the companies don’t survive. If LTVs go above a certain threshold, or a portfolio company defaults, “it could be an opportunity for the lender to reprice risk”, says Perry. 

Although such negative outcomes are rare, volatility in the macro environment is raising concerns that declining earnings could depress portfolio valuations. “If there are defaults it’s because of a degradation in value,” says Richard Wheelahan III, co-founder of debt advisory firm Fund Finance Partners. Although that may be a headwind for the growth of NAV lending, he says that “it would be unlikely to lead to realised losses because of the enormous value cushions the loans have”. 

Lawrence Remmel, a partner and chair of law firm Pryor Cashman’s banking group, says the risk that funds that engage in NAV borrowing will have to redo their valuations is very low. Banks provide a good check on the funds, with any downside risk reflected in their initial valuations and the borrowing base provided, he says. Remmel does not expect a wholesale repricing of these loans. “When they’re under stress, they will be seen to be conservative.”

One concern would be if “people start getting excessive, and put on too much leverage”, says Apollo’s Yang. But, he adds, NAV loans are “definitely designed to withstand really adverse financial conditions”.

NAV loans: What returns are achievable? 

Market participants note that compared with preferred equity, which has mid- to high-teens advance rates, NAV loans are conservatively structured, with LTVs ranging from 5-25 percent, and yields in the 10-12 percent range. 

A white paper by 17Capital on NAV lending notes that “an NAV loan of 20 percent LTV going into the financial crisis would remain less than 30 percent LTV throughout the market downturn before reverting to its opening LTV by December 2010 and steadily reducing thereafter”.

The white paper points out that “significant and persistent under performance across diversified [private equity] portfolios is uncommon, with median returns of 1.7x providing significant downside protection given low LTVs of 5-25 percent”.