Maximizing flexibility with NAV loans

Private equity funds create value mainly through well-executed portfolio company growth strategies. But no one can predict exactly how companies will perform over a fund’s life cycle. What’s more, many fund managers lack the capital to deploy game-changing bolt-on or growth initiatives for portfolio companies as their fund reaches the end of its life.

For managers seeking additional capital to support portfolio companies or invest in new assets after the majority of their limited partner (LP) capital has been allocated, the options are few. Traditional solutions that provide additional liquidity, like co-investment or borrowing at individual companies, can be dilutive, highly expensive or come with strings attached. Over the past decade, many general partners (GPs) have turned to continuation vehicles, which allow them to roll high-performing assets into new funds with additional capital from new investors to support growth initiatives. But the capital needed to create continuation vehicles is not always readily available, and it can sometimes be challenging to meet LPs’ expectations on the sale price of the underlying assets.

A less common solution, but one that is becoming increasingly popular, is securing financing against the fund’s underlying assets with a net asset value (NAV) loan. NAV loans can give managers the liquidity to support existing portfolio companies or take advantage of new investment opportunities in the later stages of a fund’s life cycle. 

For the purposes of this article, we define NAV loans as loans to a private equity fund that holds control of and/or minority positions in portfolio companies.

“In the right circumstances, NAV loans are excellent options for creating liquidity within an illiquid fund,” says Mark Thylin, head of Structured Fund Solutions for Global Fund Banking at Silicon Valley Bank.

The uses of NAV loans

Many fund managers find that NAV loans give them the ability to more fully support portfolio companies, allowing their fund to realize its full potential. NAV loans are especially useful in cases when it’s impractical to borrow against an individual company. In general, when the GP is able to borrow at the individual asset level in their fund at a competitive rate, they will. It’s when those assets are fully leveraged, or the ownership structure is such that additional asset level debt is not optimal for all owners, that a NAV loan becomes an attractive option. 

NAV loans may be used when a portfolio company needs an injection of capital late in the fund’s life cycle. They may also be used when a portfolio company is performing well and needs additional funding—for example, to take advantage of an accretive acquisition. And unlike co-investments with LPs or an external partner, NAV funding doesn’t run the risk of diluting the fund. “A lot of times, an individual portfolio company simply can’t take on the kind of debt burden necessary to make an accretive acquisition,” says Dirk Engelbert, managing director of Structured Fund Solutions at SVB. “NAV loans allow GPs to take on debt at the fund level without diluting LPs’ equity.”

In addition to the above uses, GPs occasionally use NAV loans to return distributions to LPs ahead of schedule. 

Important considerations for NAV loans

As NAV loans have become more common, their pricing has become more competitive, to the point where rates are often lower than those for senior loans for a single portfolio company.

The main limitation of NAV loans is that they are debts that by nature need to be repaid (as opposed to co-investments or continuation vehicles, which are equity-funded solutions). What’s more, that debt is at the level of the fund rather than an individual portfolio company, creating a liability that is cross-collateralized by all fund investments. “Historically, even if one or two portfolio companies don’t perform as expected, many of the others will do well and the fund will succeed overall,” Engelbert says. “But with NAV loans—or any fund-level debt instrument—the whole portfolio is supporting the loan, which can introduce the risk of cross-contamination.”

GPs should also be aware that many LPAs do not explicitly allow managers to take out financing at the fund level based on the strength of the net asset value of the fund’s underlying investments—something that’s necessary to secure NAV financing. If not permitted in the original LPA, an amendment is required before the NAV deal closes. 

NAV lending is gaining momentum

NAV loans have traditionally been more common in Europe. However, they are gaining traction in the U.S., according to Thylin. “NAV lending tends to be a more common option when the IPO market is quiet, M&A is lagging and it’s harder to go out and get liquidity,” he says.

And Thylin doesn’t see the rise of NAV loans slowing down anytime soon. “The reality is that a relatively small portion of funds currently use NAV loans,” he says. “But in five years, that number could be an order of magnitude above what it is today.”