By: Michelle Wu
Head of Marketing
August 6, 2024
The slow exit environment in private equity, that is currently defined by lack of IPOs and low M&A has resulted in liquidity challenges for private equity firms. In addition private equity funds may need access to liquidity at the later stages in a fund’s lifecycle for a variety of reasons. Those reasons include cash flow management, supporting portfolio companies, providing distributions to investors, or to deploy capital prior to realizing returns. Additionally, the latter stages of a private equity (PE) fund’s lifecycle presents unique challenges. For example, once a fund has deployed or exhausted most of its limited partners’ (LPs) capital, accessing additional liquidity to pursue new opportunities or even manage current financial obligations can be a challenge.
Traditional options like secondary sales (where firms sell their interests or stakes in their portfolio companies to secondary market buyers), co-investments or direct borrowing from other companies can be disruptive, time-consuming and expensive. Or these processes might simply not align with the fund’s strategic goals.
In recent years, an alternative solution known as net asset value (NAV) lending has gained significant traction. NAV lending allows funds to tap into the value of their existing holdings, unlocking capital for strategic investments and portfolio management initiatives without having to sell these holdings prematurely.
Below, we break down how NAV lending works, its role in the private equity landscape and its primary benefits to both PE fund stakeholders and lenders.
What is NAV lending?
NAV lending, also known as NAV financing, is a loan that’s provided by a lender to a private equity fund that holds or owns a diversified portfolio of companies. This loan is secured by the net asset value of the fund’s holdings. That is, the fund’s NAV acts as collateral for the loan much like one’s home acts as collateral for the mortgage on it.
The net asset value or NAV in this case is the total value of a fund’s investments minus its liabilities. The NAV loan is repaid from the proceeds generated by the fund’s investments.
NAV debt facilities are highly bespoke. In other words, they are individually negotiated — with the terms, structure and covenants of the loan tailored to fit the unique profile and requirements of the borrowing fund and its stakeholders.
However, there are a few common features among most NAV facilities. For example, many have conservative loan to value (LVT) ratios of 20%-30% (although some facilities can go as low as 5%). Additionally, most have maturity terms of 3-5 years.
Common NAV lenders include traditional banks, institutional investors like insurers, and specialist NAV lenders.
NAV Lending in Action
To understand how NAV lending works, let’s use a real world example.
Consider a private equity fund with a diversified portfolio of companies. Let’s say the total value of these holdings is $200 million, but the fund also has outstanding liabilities amounting to $20 million. This gives the fund a NAV of $180 million ($200 million total portfolio value – $20 million liabilities).
The fund managers identify a lucrative new investment opportunity. However, the fund has already exhausted their LPs’ capital commitments. The manager then turns to NAV lending. They identify a lender and then negotiate with them to secure a loan based on the fund’s NAV.
Here’s how everything might go down.
- Assessment and due diligence: The lender carefully assesses the fund’s NAV, confirming its value at $180 million.
- Terms: The lender offers the PE fund a loan equal to 20% of the NAV, which is $45 million (20% of $180 million).
- Collateral: The $180 million NAV serves as the loan’s collateral.
- Disbursement: The lender disburses the $45 million loan to the fund.
- Repayment: The loan is repaid over time, typically from the proceeds generated by the fund’s investments, such as portfolio company sales.
In this scenario, the fund manager is able to secure $45 million in additional liquidity without disrupting the existing portfolio or its long term growth potential. This allows the fund to capitalize on the new investment opportunity while maintaining its long-term strategy.
Role and benefits of NAV lending
NAV financing is ideal for mature private equity funds that have deployed most or all of the committed capital from investors. It offers a non-dilutive source of liquidity that can be used for various purposes, including the following:
- Facilitating additional strategic investments: PE funds can use the liquidity generated by NAV lending to seize new high-potential investment opportunities, like new acquisitions at existing portfolio companies.
- Extending investment horizon or restructuring of funds: By providing additional liquidity, NAV loans can enable GPs to restructure a fund or extend its investment horizon. This can be useful when valuable assets in the portfolio require more time to mature or when market conditions call for adjustments to the fund’s strategy to maximize value.
- Facilitating earlier capital return to LPs: NAV financing offers limited partners an opportunity to get some of their invested capital back sooner than the usual fund lifecycle would allow. This can be especially attractive for LPs seeking early returns to meet their own investment needs or portfolio rebalancing goals. Earlier distributions also translate to a higher internal rate of return (IRR) for the fund.
- Supporting portfolio companies with expiring credit facilities: NAV financing can be a lifeline for companies facing expiring credit facilities. By securing financing through NAV, the fund can help its holdings obtain capital at potentially lower rates than traditional options.
- GP commitment financing: GPs usually have a financial obligation to invest their own capital into the fund alongside LPs. This alignment of interests fosters trust and credibility in the fund. NAV financing offers a way for GPs to meet their capital commitments.
- Covering operational expenses: NAV lending can also be used to cover the PE fund’s day-to-day expenses, thus ensuring smooth operation.
Historical growth
NAV lending has experienced remarkable growth in recent years. This surge was particularly pronounced during the COVID-19 pandemic in 2020. As traditional financing channels tightened and exiting portfolio investments became increasingly difficult, NAV lending emerged as a critical source of liquidity for funds facing increased liquidity needs.
The popularity of NAV lending further escalated in 2021, fueled by record-breaking private equity deal flow. Interestingly, the growth of this sector has persisted even after a slowdown in overall private equity activity (beginning in 2022), and the easing of some pandemic-related market pressures.
According to Oaktree Capital, in 2023, NAV financing activity was up 30% and 20% year- over-year in North America and Europe, respectively. Meanwhile NAV finance deals flow more than doubled between 2020 and 2023, hitting $44 billion.
The main factors contributing to the growth of NAV lending as a financing option for PE funds can be summarized as follows.
- Market dislocations: Global market volatility has made exiting investments through traditional means more challenging, creating a sustained demand for NAV financing as a source of liquidity.
- High-interest rate environment: Traditional borrowing at the portfolio company level has become more expensive due to high interest rates. This makes NAV a more attractive financing option for private equity funds.
- Market maturation: NAV financing is no longer a novelty. Investors have grown increasingly familiar with this tool. They recognize its potential benefits and are more comfortable using it.
- Expanding lender pool: The growing popularity of NAV financing has incentivized a rise in the number of lenders offering this type of product. Borrowers stand to gain from this increased competition as it can lead to improved loan terms.
- Changing regulatory landscape: Evolving regulations have added complexity to traditional financing channels, pushing fund managers to explore alternative solutions like NAV lending.
Advantage over secondary sales
As a source of liquidity, NAV lending offers several advantages over secondary sales of portfolio assets. Let’s look at some of these advantages.
Faster and less complex process
NAV financing typically involves a quicker and less bureaucratic process than secondary sales. Secondary sales can drag on for a long time due to complex negotiations, due diligence processes, and the need to find a buyer willing to meet the seller’s valuation expectations.
On the other hand, NAV financing relies on the established net asset value of the fund, bypassing the need for extensive negotiations on the overall price. The ultimate result is faster deployment of funds.
Value preservation
Secondary sales often result in investors selling their interests at a discount to attract buyers. This discount can be significant, especially during economic turmoil or uncertainty. For example, industry statistics show that the average buyout funds commanded a 13% and 9% discount to their underlying net asset value in 2022 and 2023, respectively.
NAV financing allows GPs to access liquidity without having to sell some of the fund’s assets at a potentially undervalued price. This helps funds preserve the long-term potential and value of their investments.
Confidentiality
NAV financing offers a more discreet way to raise capital. Secondary sales are more public, potentially signaling to the market that the PE fund is facing liquidity issues or other challenges. NAV financing, on the other hand, can be arranged privately, minimizing any negative market impact and safeguarding the fund’s reputation.
Flexibility
NAV financing offers greater flexibility and customization compared to secondary sales. Lenders can structure the financing to cater to the fund’s specific needs.
Benefits to lenders
NAV financing offers a compelling lending opportunity for creditors, balancing attractive returns with manageable risk. Here’s why:
Diversified collateral and conservative loan-to-value (LTV) ratios
As mentioned, NAV financing is typically extended to funds owning a highly diversified portfolio of companies. This reduces the risk of loss from a single asset’s underperformance. Additionally, lenders don’t extend the full NAV value but rather a set percentage (LTV ratio) – often ranging from 20% to 30%. This further mitigates risk.
Unless a fund’s entire portfolio declines significantly (which is incredibly rare), it’s quite unlikely for a NAV lender to experience loss.
Senior debt position
NAV financing typically takes a senior debt position in the fund’s capital structure. This means that NAV lenders are repaid before other creditors and equity holders in the event of liquidation or bankruptcy. This seniority significantly reduces the risk for lenders.
Overall, NAV lending presents a mutually beneficial arrangement. Lenders can achieve attractive returns with mitigated risk, while private equity funds gain access to essential liquidity to optimize their portfolios and refine their investment strategies.
Future of NAV lending
Looking forward, PE experts expect the NAV financing sector to continue growing due the factors cited earlier. Estimates are that the overall NAV finance market could hit $700 billion by 2030, up from $100 billion in 2020, according to 17Capital.
Final thoughts
NAV lending has emerged as a powerful and versatile tool for private equity funds, offering a compelling solution for unlocking liquidity.
By leveraging the value of their existing investments, GPs in PE funds can access capital to meet various needs or objectives without disrupting their investment strategies or sacrificing ownership of promising assets. For lenders, NAV financing presents a low-risk investment opportunity with attractive returns.
At Allvue Systems, we understand the power of NAV lending and are committed to providing you with the technology and support you need to optimize it as a financing strategy.
Our state-of-the-art private equity software comes with advanced solutions tailored for NAV financing success, including comprehensive portfolio analytics, real-time valuation calculation, risk management, automatic report generation and sharing, and more.
Contact us today to learn more about how we can help you navigate the exciting opportunities of NAV lending.
Sources
Oaktree Capital: NAV Finance 101: The Next Generation of Private Credit. https://www.oaktreecapital.com/docs/default-source/default-document-library/nav-finance-101.pdf?sfvrsn=6e1e5766_2
17Capital. Why 2022 was another record-breaking year for NAV finance. https://www.17capital.com/why-2022-was-another-record-breaking-year-for-nav-finance/
Financial Times. Private equity stakes unloaded at a discount as investors seek exits. https://www.ft.com/content/a1612484-6511-41f3-9e3a-83eb2dea0347
More About The Author
Michelle Wu
Head of Marketing
Michelle is a dynamic marketing leader with 15+ years of experience in capital markets, fintech, and cybersecurity technology industries. Prior to joining Allvue, Michelle was the Vice President of Product Marketing at SecurityScorecard, a global leader in cybersecurity ratings, and was the Head of Security & Compliance Marketing at Box. Before moving into cybersecurity, she led the Banking & Securities GTM strategy at Intralinks and covered capital markets clients at HSBC. She holds an MSc in Media & Communications from the London School of Economics and a BS in Marketing & Finance from NYU Stern School of Business.
