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The ‘small’ approach that’s big news in fund finance

Up to now, net asset value-based fund finance facilities have mainly focused on broad, diversified portfolios, but that may be changing.

Khizer Ahmed, Matthew Kerfoot and Edward Newlands

Solutions emanating from fund finance continue to play an important role in the eco-system of the private capital funds industry. Credit lines secured by portfolios comprised of a small number of assets – ‘concentrated net asset value facilities’ – have garnered interest among GPs in the private markets.

At a macro level, concentrated NAV facilities can be distinguished from traditional NAV facilities by the nature of the collateral that secures such borrowing. Whereas most NAV facilities are secured against diversified pools of assets (such as borrowing by a private equity secondaries fund secured by multiple LP interests in a range of underlying funds and strategies), concentrated NAV facilities are generally secured by a small number of underlying assets. It is not uncommon to come across only two or three underlying assets comprising the bulk of collateral value supporting a facility. We recently worked on a transaction where a fund’s borrowing was secured by a single portfolio company.

There might be any number of reasons why borrowing at the fund level in the form of a concentrated NAV facility would be preferable to that at the individual portfolio company level. A company might have an over-levered balance sheet to begin. It might be going through a difficult or transitional phase in its corporate life and, therefore, may not have unfettered direct access to debt financing. It may have breached its loan covenants and face an effective freeze in the corporate loan markets. Economic or financial market conditions may reduce the supply of new debt finance or make it more expensive to refinance existing debt. Finally, diversification among lenders in the fund eco-system and a reduction in exposure to correlated action by a small subset of lenders in the event of a system-wide stress event is a sensible objective in its own right.

Why now?

The concept of NAV-based finance facilities as a bona fide portfolio management tool is well known to, and understood by, most GPs. In contrast, concentrated NAV facilities are a somewhat niche product and have only recently entered broad-based discourse.

There are a few contributory factors. The covid-19 crisis has dramatically changed the financial and operational landscape for privately owned companies. Falls in revenues for companies across multiple sectors of the economy, and opacity with respect to the timing and extent of any recovery, have been accompanied by a pull-back in debt financing from traditional sources.

Like others, private equity-owned companies have taken steps to shore up liquidity where possible. LPs have been asked to contribute additional capital to funds that are still within their investment periods and portfolio companies have drawn down on existing bank credit lines where available. Challenges still remain, most notably in the form of a fall in distributions, the relatively sluggish pace of activity in the secondaries market, relatively subdued valuations for companies contemplating primary stock market listings and, where they still exist, a revision downwards of bids from potential buyers of individual portfolio assets.

“We recently worked on a transaction where a fund’s borrowing was secured by a single portfolio company”

Notwithstanding notable exceptions, the majority of GPs raising new funds have found asset raising to be sluggish. All the while, market dislocations and a general pull-back in valuations continue to uncover potentially attractive new buying opportunities.

It is little wonder then that GPs have shown a greater interest in underexplored portfolio financing-based liquidity solutions. They are doing so both to deal with immediate and emerging portfolio needs as well as with a view to positioning their portfolios more robustly to take advantage of emerging opportunities. Concentrated NAV facilities fit the bill as one such solution.

As a tool targeted at portfolio companies, a key benefit of fund-level concentrated NAV facilities is their functionality in addressing an equity need at the cost of debt. Given the non-dilutive nature of debt versus equity, the overall economics are likely to look attractive from an equity investor’s perspective. Such facilities can be structured flexibly to suit a borrower’s requirements – the borrower can be a fund, special-purpose vehicle or individual portfolio company, and collateral arrangements can be tailored to suit the structural features of a given transaction.

Another benefit is that most concentrated NAV facilities contain few covenants at the individual company level. These facilities rely on fund- or portfolio-level credit risk mitigation mechanisms, thereby imposing a lighter burden of compliance. Also, experience shows that such facilities are quicker to execute than bilateral credit facilities secured at a single company level.

Some considerations

A borrower should consider a number of factors, and meet certain prerequisites, before engaging lenders in conversations about concentrated NAV facilities. On the assumption that a GP does not have recourse to existing liquidity mechanisms – such as LP committed capital or a pre-existing fund level credit facility – that might be cheaper or quicker to access, a careful review of a fund’s limited partnership agreement to identify any restrictions on the introduction of fixed-term debt at the fund level is a logical starting point. Engagement of the fund’s LPs with a view to seeking their agreement to any financing transaction is likely to follow soon after. Identification of assets to be pledged as collateral, and analysis of structural issues around these, are other early-stage considerations.

“A possible reduction in reliance on banks as the sole or main providers of fund-level debt financing is also a notable ancillary benefit”

Finally, careful thought needs to be given to headline terms that are likely to form the core of any financing transaction. Some of the more obvious ones in this respect include: the use of proceeds; what the drawdown schedule is likely to be, given portfolio requirements, including the potential need for a delayed-draw feature; a suitable loan-to-value attachment point; the level at which borrowing is likely to take place (fund, wholly owned subsidiary/SPV, individual portfolio company); the availability or potential use of guarantees as a supplementary credit support mechanism; cash versus payment-in-kind coupon; maturity; proposed repayment waterfall; and mechanisms for addressing any potential early termination events or events of default.

Banks or speciality lenders?

Whereas large, well-known banks dominate the provision of diversified NAV credit facilities, the main players in the concentrated NAV facility business appear to be speciality finance companies that operate through dedicated vehicles funded by a combination of institutional and non-institutional investors. The relatively high balance sheet capital charges associated with such facilities appear to be one reason why most mainstream banks shy away from this segment of the fund finance market, though a few notable exceptions do exist.

Another reason is the requirement by banks for their NAV-based credit exposure to be secured by well diversified pools of assets. By definition, concentrated NAV facilities do not meet this requirement. The size of transactions can also be a hurdle. It is common to come across transactions in the $10 million to $25 million range in the concentrated NAV facility business. For most large banks, this is too small, given the amount of work involved and other considerations highlighted above.

“The ongoing covid-19 crisis has dramatically changed the financial and operational landscape for privately owned companies”

Concentrated NAV facilities can be expensive, particularly when compared with traditional NAV financing backed by large, well-diversified portfolios of assets. It is not atypical for the all-inclusive cost to be in the high-single or low-double digits, particularly when borrowing from a non-bank lender. As with debt transactions more generally, pricing for a given transaction is a function of a number of factors, including the LTV ratio, maturity, the diversification (or lack thereof) in the collateral pool, use of proceeds, and existence (or otherwise) of additional risk mitigation mechanisms. Pricing differences between different lenders are only one dimension that borrowers should consider as they evaluate multiple offers. Qualitative factors, such as flexibility of use, covenants and cure mechanisms should an event of default materialise, are arguably as important in forming a view about the overall attractiveness of a given offer.

Where next?

The covid-19 crisis has given significant publicity to the concentrated NAV product and familiarity is only likely to grow in the foreseeable future. Their relatively high cost notwithstanding, once concentrated NAV facilities have been deployed they can prove to be multi-use and can provide GPs with a flexible tool to address a wide range of portfolio objectives. This can prove attractive in an environment where traditional lenders are likely to continue to tread carefully with respect to increasing their credit portfolio exposures.

The highly bespoke nature of such facilities, which are designed to achieve close alignment with borrower requirements, and the relative speed of deployment are among the other compelling features. A possible reduction in the reliance on banks as the sole or main providers of fund-level debt financing is also a notable ancillary benefit. The use of concentrated NAV facilities looks set to grow in the foreseeable future.

Uses and benefits

Concentrated NAV facilities can be used to meet a range of objectives, either at the level of the fund or at that of an individual portfolio company. When directed towards individual portfolio companies, these facilities have been used to:

• capitalise on bolt-on growth opportunities
• provide portfolio companies with financial cushions before sale or for
purposes of a pre-exit balance sheet clean-up
• cure debt covenant breaches
• refinance expensive preferred equity or debt financing
• buy out co-investors in single asset investments
• finance early (partial) distribution to existing fund LPs without asset or
portfolio sales
• provide warehouse financing for acquisitions and future syndication
• access bridge financing between fund closures in instances where
fundraising has progressed slower than expected
• undertake contingency planning with respect to capital availability
during periods of market stress

Khizer Ahmed is founder and managing member of Hedgewood Capital Partners, a New York-based fund financing advisory firm. Matthew Kerfoot and Edward Newlands are both partners in the New York office of law firm Dechert