It used to be that a GP and its club of lending banks were inextricably linked. In the halcyon dealmaking days at the turn of the millennium, if a private equity player wanted to underwrite a new deal, the default option would be to arrange a loan with one or more of its relationship banks.
Today, much has changed. Turning solely to trusted banks to arrange acquisition finance is no longer standard operating procedure. As the PE industry has evolved – in tandem with the increase in choices of the forms of available financing – so has the way investment firms arrange finance. Nowadays, a direct lender is more likely to be the first choice for capital.
Partly as a result of the increased regulation of banks in the wake of the global financial crisis, direct lending was one of the more significant developments to address the demand for flexible financing for the ever-evolving PE industry. Now, a new form of portfolio financing has emerged: net asset value-based credit lending.
The parallels between this new trend and the rise of direct lending are startling. NAV-based credit has rapidly established itself as both a portfolio management tool and as an investible asset class in its own right. It may become to today’s private equity investors what direct lending was to dealmakers and investors at the start of the 21st century.
How it works
Pioneered in 2008, portfolio financing allows investors across the spectrum of the private equity industry – from GPs to LPs – to access non-dilutive, highly flexible financing in return for exposure to the cashflows of a basket of underlying portfolio companies, often using preferred equity instruments.
This financing can be used for a variety of strategic purposes. These include raising capital for further investment in portfolio companies; accelerating liquidity and distributing capital back to investors or indeed for the GP itself; and providing non-dilutive capital and financing to enable the manager to increase its co-investment amount, manage succession planning or seed new strategies on the balance sheet.
The market for portfolio financing in private equity has grown significantly since its beginnings and continues to expand. There are more than 800 fully called buyout funds globally that could use fund-level financing solutions for strategic purposes. There is also around $660 billion of NAV in global buyout funds with 2010-16 vintages, where liquidity may be constrained and portfolio financing might be a solution.
Although preferred equity-based portfolio financing has firmly established itself among the top-quality players in private equity, more recently there has been increasing demand for a complementary credit-based solution. Preferred equity is incredibly flexible and efficient. It is often cheaper than a secondary sale, acting as an attractive alternative for GPs and LPs looking to make strategic investments or to help fund liquidity.
But in many cases, sponsors are seeking lower loan-to-value ratios, own more diversified portfolios, and do not have the need for the equity-like flexibility that preferred equity provides. This is where NAV-based credit fills the gap.
It is a logical and complementary expansion of preferred equity-based portfolio financing, and can be used in the same ways as a strategic tool for investors across the PE spectrum.
Competitively priced NAV-based credit was previously challenging for many finance providers to offer, and banks have been hesitant to move into the space. Traditional lenders have historically been restricted in terms of the type of NAV credit they can provide. They have mainly offered it to their core clients, if they have offered it at all.
We are seeing the advent of new products from dedicated portfolio financing firms beginning to fill the gap in the market at an attractive price point. To their advantage, these providers can apply a more flexible approach to structuring and are not as constrained as other providers.
The future looks bright for NAV-based credit financing. The overall market for PE portfolio finance is continuously growing as the industry matures. More and more GPs and LPs are treating it as an essential component in their portfolio management toolbox. Its adoption by private equity’s top-quality players is also triggering a wave of interest across the sector.
The impact of covid-19 on liquidity has accelerated this. There has been even greater adoption of the product as GPs look to support portfolios through challenging periods and LPs deal with allocation and liquidity constraints. This trend is set to continue in an industry where competition is at an all-time high, with GPs increasingly turning to new ways to finance growth or liquidity in their portfolios, as well as the growth of their own organisations.
The past 20 years have been a period of significant innovation and growth for the PE and private credit industries. In the next 20 years, we will look back on NAV-based credit in the way we view direct lending today. What was once a small niche in the market will become an invaluable and widely used strategic tool.
Thomas Doyle is a partner at 17Capital, a provider of finance for investors in private equity