A largely untested caveat attached to one of private markets’ hottest trends is drawing the ire of some investors who feel they are on the receiving end of phantom performance metrics.

NAV loans have grown from a niche part of the market to a more widely adopted form of fund finance, sometimes used to accelerate distributions and deliver cash back to LPs, or invest further in existing portfolios. A GP may want to expedite a distribution to help cash-strapped LPs re-up in the manager’s fund – increasing the distributed to paid-in ratio in doing so.

Carlyle Group, Hg and Vista Equity Partners are examples of firms that have taken out NAV loans in recent years for this and other reasons.

But distributions made from NAV loans are now coming under the microscope for their “recallable” nature, according to discussions with multiple institutional investors who have received such distributions. At least one of the two distributions Vista has given to LPs via a NAV loan has been recallable, according to a person familiar with Vista’s funds.

“It is important to see if a distribution made from a NAV facility is classified as recallable,” says Stefan Fallgren, an investment director at Sweden’s Skandia Mutual Life Insurance Company. “This should be stated in the distribution notice and if not, one should double check. If so, the GP can ‘recall’ that capital from LPs who need to have that money ready to repay.”

For some LPs, receiving recallable distributions means they can’t use the capital for other purposes, as it must be kept on hand in the unlikely event it is recalled. Several LPs affiliate publication Private Equity International spoke to say such distributions are simply returned to their unfunded commitment allocation for the given fund.

“[The] NAV goes down because we get the money,” Fallgren says. “The equity in the fund goes down, but our remaining commitment goes up. For us, it’s a zero-sum game.”

Other LPs echo Skandia’s sentiment. Allen Waldrop, director of private equity at the $77.7 billion Alaska Permanent Fund, says a recallable distribution “doesn’t really count as a distribution” if an institution’s accounting rules mean the capital must be held back against unfunded commitments.

“I don’t think it makes any sense to borrow money to send distributions back to your LPs,” Waldrop says. Recallable capital could “wreak havoc” when it comes to performance metrics, he adds.

“The GP will say our [distributed to paid-in] is 0.5x, and you’ll [say], well, we’re not showing any distributions from you. We showed it as a net against a contribution because it’s recallable. I think there are issues to sort through there.”

One major bone of contention appears to be around the use of NAV facilities to distribute cash to LPs in the expectation that this will help them re-up in a sponsor’s successor fund – either by providing them with cash, or by helping to increase the distributed to paid-in ratio.

Market sources point out that for the lender, stipulating that all or a portion of any capital from a NAV loan that is used for LP distributions be recallable shifts the ultimate risk away from the assets held in the fund and onto the LPs.

“It’s recycle capital basically, it’s a win-win [for GPs] but no help for LPs,” says the head of private equity at a large Europe-headquartered institution.

The rationale for recall

It’s unclear to what extent recallable NAV loans are standard market practice. A portfolio manager at a multi-billion-dollar US-headquartered insurance company tells PEI recallable capital is dependent on terms agreed in the LPA of a fund.

“For the capital to be ‘recallable’, the recallable portion often has needs to meet certain conditions – often within a certain period from when drawn, to be used for a specific purpose, within investment period – for the GP to be able to draw,” the manager says. The GP may not have unfettered discretion as it may have for ‘pure’ undrawn capital, he adds.

Gabrielle Joseph, head of due diligence and client development at placement agent and advisory firm Rede Partners, which has advised on numerous NAV loans, says that while it always depends on the provisions stipulated in an LPA, most NAV loans are recallable from a legal point of view. In practice, this is never enacted or expected, she adds.

Legal experts say it is not unusual for distribution proceeds from any realisation to have some provision for recallability.

“Typically, most fund documents have some provision that says a certain amount of disposition proceeds are recallable, subject to certain limitations, amounts, time periods and other things, and often a refinancing of an investment is deemed to be a disposition,” says Fadi Samman, a partner at law firm Akin.

If a fund sponsor deems a NAV loan-based distribution as a disposition, the distribution will be subject to the rules of the fund documents on the recallability of disposition proceeds, he adds. In most cases, the rationale for making distributions recallable from LPs is so the GP can invest in an asset, says the portfolio manager at the US insurer.

“Within 10 months [for example], that company is sold and the money returned to the LPs. In this scenario the GP only has the use of the money for 10 months which is not the intention in a 10-year fund. Hence, the concept of recallable capital was created to allow the GP to put that money to use again.”

PEI understands that the Institutional Limited Partners Association is exploring this topic with LPs in relation to the upcoming guidance.

Some LPs, however, have already taken a view. “We can’t stand [NAV facilities],” one senior investment executive at a foundation tells PEI on condition of anonymity. “We don’t want to pay a bank an eye-watering fee to get our cash back earlier, so we push back hard on those. GPs are free to do it but it’s still a question of then what happens at the next fundraise.”

The growth of these types of NAV loans financing has been rapid and exponential and there is a need for explanation and guidance – particularly at the LPAC level – to ensure interest alignments are maintained, says Alexandre Armbruster, head of private equity and infrastructure funds at the €244 billion French public pension manager Caisse des Dépôts et Consignations. There has been “almost nothing” about NAV loans in LPAs CDC has been a party to to-date, he adds.

Impact assessment

Investec, a large player in the NAV loan market, has not come across situations where GPs to whom it has provided NAV loans have recalled capital from LPs, according to Grant Crosby, head of fund solutions at the bank.

“Overall I think LPs are benefitting from NAV loans whose purpose is to create early redemptions,” Crosby says.

NAV facilities create liquidity for LPs in a relatively illiquid market and may be more economically viable than selling a fund stake on the secondaries market, he adds. Most large institutional investors with treasury functions manage their liquidity on a portfolio basis as opposed to deal-by-deal, so even in the rare event there is a recallable distribution that is exercised, the impact should not be extensive, he says.

According to Rede’s NAV Financing Market Report 2022-23, 61 percent of lenders saw an increase last year in the number of NAV financing transactions for which the sole purpose was improving DPI.

However, one senior executive at a Europe-based fund finance provider tells PEI that while NAV facilities used for distributions were common in the first half of this year, they are now more frequently being used for reinvestment purposes.

Still, for LPs facing liquidity needs or who are eager to demonstrate improved DPI ratios, distributions via NAV loans can be a welcome or early surprise. For others, they can be an expensive and unnecessary form of financial engineering. That they may also be recallable appears to be frustrating from a cash management perspective.

“We don’t have that immediate need for liquidity,” says Skandia’s Fallgren. “It doesn’t add anything, it just costs [us].”

– Chris Witkowsky and Madeleine Farman contributed to this report.