Investors in private markets funds have had to play a waiting game when it comes to receiving distributions from managers.
Rising interest rates have put the brakes on M&A and IPO activity, forcing managers to hold portfolio companies for longer. Buyout funds in North America, for example, saw hold periods rise to 7.1 years in 2023 – the longest hold average hold period in more than two decades, according to the Preqin figures reported by S&P.
Bain & Co analysis of Preqin data, meanwhile, shows buyout managers sitting on a record $3.2 trillion of unexited companies in their portfolios.
With exits at a premium and liquidity more prized than ever, managers are exploring all options available in an effort to realize value and start making distributions to investors.
In the second of a four-part series exploring the alternative routes to liquidity that managers have available, Alter Domus looks into how the NAV finance industry has stepped up to offer new routes to liquidity for managers.
Part 2: NAV Finance
Less than a decade ago there would have been few corners of the capital markets ecosystem that would have been as less understood then NAV Finance.
Sponsors would have used other fund finance tools, such as subscription line finance (where sponsors take out short tenure bridging loans to streamline the capital call process) regularly, but NAV finance, where managers take out loans secured against the underlying portfolio companies in their funds, was a small, niche part of the market, used by only a handful of managers.
During the last five years, however, the NAV finance has undergone a remarkable phase of growth. Between 2020 and 2023 NAV finance more than doubled to around US$44 billion, according to figures from 17Capital, an NAV Finance market pioneer.
The shuttering of mainstream financing sources in the immediate aftermath of the first pandemic lockdowns, followed by the rising cycle of interest rates in 2022 and 2023, saw the NAV finance option rise to prominence.
NAV loan terms are bespoke, and can offer loan-to-value (LTV) ratios starting at ten percent of the NAV part of a portfolio, with scope to move as high as 60 percent for quality portfolios that are highly-diversified, with spreads varying accordingly.
Relatively low LTV ratios, and the fact that NAV loans are cross-collateralized and secured against a portfolio of assets in a fund, rather than individual portfolio companies, has made the product an attractive option for lenders and investors, helping to grow the market. At Alter Domus, we have seen firsthand the growth of this trend and supported our clients to maximize the opportunity.
A liquidity lifeline for GPs
For managers, NAV finance has become a valuable source of additional liquidity, particularly given the tight financing conditions of the last 24 months.
Managers have used NAV finance in different ways.
For managers that have built up a solid portfolios of assets, but are approaching the end of the typical five-year investment period, NAV finance has served as a source of capital to fund additional rounds of platform company acquisitions or inject further capital into portfolio companies where they continue to see opportunities and the opportunity set has surpassed initial growth plans.
A NAV loan can provide a cheaper line of capital to fund these opportunities and save managers from having to deal with the complexity of extending investment periods or bringing in additional outside equity.
NAV finance can also be used to support portfolio company refinancings and capital structures. Rather than individual portfolio companies having to carry the load of more onerous refinancings in a higher rate environment, a manager can bring in financing at fund level to maximize operating leverage without squeezing headroom at individual portfolio company level.
In recent years, managers have also used NAV loans to help finance GP commitments and in some cases, managers have also used the products to make distributions to investors.
Rather than selling assets into weak M&A or IPO markets, where vendors will more than likely have to accept discounts to NAV, even for quality assets that would trade at a premium against a different macro-economic backdrop, sponsors have taken out NAV loans and used the proceeds to make distributions back to investors.
In an otherwise illiquid market, this has enabled managers to send cash back to investors without having to sell prized assets into a down market.
In a NAV structure, where LTVs are calculated at NAV, rather than at a discount to NAV, managers can take out liquidity without having to compromise on valuation.
On the whole, investors have accepted that NAV financing can provide a cost-effective way to support and fund portfolio companies beyond initial investment periods.
There are, however, also concerns among investors that NAV loans are adding further layers of debt into already leveraged private equity structures, and that there the cross-collateralized nature of NAV loans can see stronger companies in a portfolio impacted by under-performance in weaker portfolio companies.
Some LPs have also been skeptical of the sustainability of using NAV loans to unlock liquidity for distributions.
These reservations will have to be addressed by managers and NAV financing providers, but even though some stakeholders are yet to be fully convinced of NAV finance’s value, there is momentum and a track record behind the industry that will see it continue to grow.
As more managers use the product, 17Capital and Oaktree Management (which acquired a majority stake in 17 Capital in March 2022) are forecasting that NAV finance could grow into a $145 billion market by 2030.
A liquidity lifeline for GPs
For managers that want to take advantage of the flexibility and liquidity that NAV financing can provide, it is crucial to have the necessary operational and technology backbone in place to be able to track and report on how NAV facilities are used and serviced.
Given some of the investor concerns around the use of NAV financing listed above, transparency is essential for securing long-term investor buy-in, which will require back-office teams to clearly communicate and engage with LPs on NAV loan usage in accounts and investor reports.
Managers will want to avoid situations where LPs find out about the use of NAV loan facilities before a manager has proactively disclosed that it has taken out an NAV loan facility.
There are further reporting and accounting demands that come with NAV loans. Investors will expect reports on how the use of additional leverage at fund level is impacting distributions and returns.
Distributions from NAV loans can also be clawed back in some circumstances, with tax, cash flow, and interest cost implications that managers should be modelling and disclosing.
Back-office teams will also have to be able to produce regular NAV calculations in order to establish LTV ratios (rather than the typical quarterly NAV reports) and will also have to account for the potential impact of a weaker company’s default on the wider portfolio, given the cross-collateralized nature of the typical NAV loan structure.
Taking on a NAV facility can squeeze back-office teams that are still coming to terms with the ever-rising regulatory, reporting and disclosure requirements that managers have had to deal with in recent years.
Working with a third-party fund administration partner like Alter Domus can help managers to scale-up their back-office capability without having to incur high capital expenditure technology and staff costs.
We work with managers as a co-sourcing or outsourcing partner, and also counsels managers on how to select and implement best-in-breed alternative assets software to improve operational efficiency
Fund administration specialists will also have the experience and technical capability to handle the reporting and disclosure requirements that come with taking on NAV loan facilities, giving managers piece of mind that their organizations are tracking NAV loan usage and providing accurate and regular reports to investors on the facilities.
Finally, we have the scale to make investments in proprietary technology, powered by AI, that help back-office teams to handle higher volumes of work and have the bandwidth to cope with NAV loan reporting and disclosure requirements.
As mentioned in the first article in this series, Workflows is an AI-powered application that automates high volume back-office tasks, freeing up key back-office resources to handle bespoke and complex NAV loan facility disclosure and reporting work.
Managers who have a solid operational foundation place will be in the best position to take advantage of the flexibility and a liquidity that NAV finance provides at a point in the cycle when mainstream sources of capital remain constrained and conventional exit pathways narrow.
