Fundraising, deployment and divestment rarely goes precisely according to plan. Having an additional source of finance at a time of need can provide benefits for managers and investors alike.
Defined and meticulously planned portfolio company growth strategies are an integral aspect of a PE firm’s ability to create value. But, despite best efforts to influence and predict how a particular company will grow and crucially, how the market it operates within will have developed – well, no one has a crystal ball. An increasingly common predicament for managers is finding game-changing bolt-on or growth opportunities for portfolio companies as their fund reaches the end of its life, whereby dry powder or financing options to enable them to act are limited or unavailable. Alongside this, increasingly, funds are losing out on potential gains because they are being forced to sell companies to meet timing obligations of the ten-year structure.
For managers seeking additional capital to take advantage of portfolio company growth opportunities as the fund nears the end of its life, the options are few. “Thinking logically, when you get to the end of fund and more capital is required the avenues open are limited,” explains Jeremy Hand, Managing Partner of Horizon Capital. “It’s traditionally co-investment, which requires management and can be dilutive, or expensive debt sometimes with strings attached.”
Of course, as the private equity market matures, solutions addressing capital inefficiencies are emerging. The most obvious being today’s booming secondaries market, driven by LPs seeking greater optionality and liquidity over their private equity exposure.
While the rapid growth of this market has increased the industry’s attractiveness from an investor perspective, secondaries fail to consider the needs of underlying assets.
A less well-known but seemingly neat solution is to secure finance against the underlying assets, which takes into account the individual portfolio company needs – allowing managers to better support their portfolios.
“It is a far more esoteric arrangement, suited to funds where the investor base may be unwilling or unable to support further, and very often are prevented from long term borrowing by the LPA, you can look to the underlying assets instead,” explains one senior PE practitioner. “Putting a layer between the fund and portfolio, enabling capital to be drawn down and allocated as needed is a neat solution.”
The most obvious benefit to this form of capital is the economics. It is far more cost-effective to borrow against a pool of diversified assets than on an individual company level. Furthermore, it is may be easier to source in certain instances. “Getting debt at the portfolio company level can take months, especially at the point of acquisition, and the terms might not be great given that banks prefer to see a level of track record. Even then, the debt may still be expensive and structurally limiting, potentially putting the firm’s equity investment at risk,” notes Jesse Hurley, Head of Silicon Valley Bank’s Global Fund Banking Practice.
But most compelling is the flexibility it affords managers to realise the full potential of their portfolio, thereby enhancing returns. Says Hand, “It provides additional capital to support the buy and build programme of our portfolio companies. It has allowed us to take advantage of opportunities to enhance returns at a lower cost than dilutive co-investment or individual portfolio company borrowing.”
A further benefit of this kind of financing is the ability to fully deploy the entire fund. “Depending on the LP agreement, managers often hold back 10-20% of the vehicle for follow-on funding,” notes Hurley. “But through NAV facilities, GPs can fully invest the fund, thereby increasing the opportunity to generate better returns due to investing more capital. It provides them a greater sense of freedom and flexibility.”
Bridging facilities have become commonplace is today’s market, however concerns around over-levering have understandably risen to the fore. It is therefore important to understand the clear distinction between the use and limitations of NAV facilities.
Says Hurley, “It’s mostly not used as fund-level leverage. It’s typically used on a case-by-case basis, where portfolio company A needs a capital injection later on in the investment life. This type of financing, which is normally a small turn of debt (often in conjunction with equity and senior secured debt), provides a neat solution.”
“The other case we see is when a portfolio company is performing well and needs follow on funding, perhaps to take advantage of an accretive acquisition. In a fully deployed fund, the GP’s options are 1) open up that deal for co-invest with the LPs or an external partner (diluting the Fund), 2) bring in expensive and risky mezz, or simply pass on the acquisition all together. NAV financing may be a more attractive financing option, in terms of fund economics for the manager,” adds Hurley.
Given the multiple benefits of NAV facilities, it is interesting to note their current take-up. “In general, these facilities are better known and used in US and European markets. Asia is slightly lagging, which is understandable as the overall private equity market is younger,” observes Hurley.
Increasing access and efficiency of capital throughout the private equity fund cycle forms part of the industry’s natural progression. “Given private equity’s maturity, where there are more funds wanting more time to unlock the potential of their portfolios, people are looking for more effective and efficient capital. This is something that has gained traction in the US – Europe is likely to follow,” believes Hand.
Indeed, when the structure was first set up several decades ago, for the then nascent US venture capital market, the ten-year life span was appropriate for determining the success of start-ups. Says Julian Mash CEO of Vision Capital, “The nature of assets held by private equity today is different to what funds were originally created for. The assets are often more mature and may not be suited to ownership changes every few years. There’s a mismatch between what’s best for companies and fund lives.”
While these facilities have been created to support the industry’s evolution and increasing sophistication, given wider macroeconomic dynamics, a major uptick in their use appears inevitable. “Any kind of downturn will propel this product into the mainstream. Combined with increased awareness, it is likely these facilities will become more common,” says Hurley.