Developments in Fund Leverage: NAV Financing and Co-Invest Facilities
Limitations of the Traditional Subscription Financing
Subscription financings have long been used by private equity and other funds in order to provide a short-term bridge to calling capital from their limited partners (as a preferable alternative to requiring investors to satisfy multiple capital calls for various purposes over a short period of time), and to finance the payment of the fund’s costs and expenses. Given the nature of this type of financing, subscription lines are usually structured as revolving credit facilities, such that they can be drawn, repaid and re-drawn as necessary.
A subscription financing is generally credit profiled against the strength of the undrawn capital commitments of the fund’s investors, as opposed to the performance of the fund and its underlying investments. In this way, subscription-based financings are often described as “upwards-looking” financing products. A structure diagram showing a typical structure for a subscription financing is shown above.
This fundamental feature of a subscription financing gives rise to a number of key limitations, making the subscription financing unsuitable or unattractive in certain situations. Principally, given that this type of facility is predicated on the amount of investors’ capital which the fund may draw on, a mature fund which has already called and invested a large part of its limited partners’ commitments may find that it can only raise a small subscription line, or that the cost and effort associated with arranging one outweigh the benefits. Equally, a fund whose investment period has expired, but which still holds several investments in preparation for an exit, may not be able to raise a subscription line at all.
Furthermore, as a revolving credit facility, a subscription line generally provides only a short-term financing solution. This characteristic makes it generally unsuitable as a method of incurring permanent debt, which in turn typically means that it is unable to be used to leverage the fund’s underlying investments, or to unlock capital from those investments to finance an early distribution to investors, which may be of increased importance for private equity funds. Finally, a fund subscription line is clearly not suitable for individual investors seeking to leverage their own investments in a fund.
These limitations of a traditional subscription financing are addressed, at least in part, through two alternative fund leverage products: NAV financings and co-invest facilities.
A NAV (or net asset value) financing is in many ways the mirror image, conceptually speaking, of a traditional subscription financing, although they share many of the same key features. Unlike an “upwards-looking” subscription financing, NAV financings are predicated not on the uncalled capital commitments of the fund’s investors but instead on the value of the fund’s underlying investments themselves – and accordingly can be described as a “downwards-looking” financing.
This pivot in credit profile, from upwards- to downwards-looking, makes a NAV financing much more suitable from the mid-life of a fund when significant amounts (or all) of its capital have been deployed and undrawn commitments are low. In this way, a NAV financing can be used by borrowers to add further leverage to their underlying investments. It is a common tool of secondary funds to achieve the financial engineering required to meet their return profile. Similarly, in a private equity context, a NAV financing may be used as a method of achieving a synthetic or partial exit (and thereby increase the fund’s Internal Rate of Return), by unlocking capital from some or all of the fund’s assets to return to investors in a situation where a full exit may not be possible due to macroeconomic or geopolitical reasons, for example. This partial exit can be achieved while preserving the ability of the fund to sell its remaining assets at a more favorable time (and a more favorable price) thereby gaining any upside (net of the financing cost of the NAV facility).
Whereas one of the key components of a subscription financing is the borrowing base (being the pool of uncalled capital from eligible investors which the fund can borrow against), a NAV financing is generally focused on an LTV (loan to value) test, which requires that the amount of debt drawn under the facility does not exceed a given percentage of the net asset value of the fund’s underlying investments. As is the case with a subscription line’s borrowing base, this is a dynamic metric which fluctuates over time as investments are acquired, held and disposed of. A typical “advance rate” (being the amount of credit which a lender will extend against the value of a particular asset) is often low, in the region of 10% to 15%, although stronger borrowers with a healthy track record may often achieve an advance rate of up to 25%.
The pricing of NAV facilities depends largely on the nature of the underlying assets but are often seen in the 7 – 8% over LIBOR range. Whilst “top tier” borrowers may be able to achieve pricing of LIBOR plus 4.5% – 5.5%, for certain more challenging portfolios (which are overly concentrated or have a high LTV ratio) the pricing may approach preferred equity levels, which should lead to a conversation as to whether a preferred equity structure is more appropriate for that situation. Maturities are often seen around the three-year mark.
The loan-to-value covenant will be tested periodically, as well as on the occurrence of certain trigger events (such as a request for borrowing a new loan, the disposal of an asset, the receipt of a distribution, and so on), with the relevant transaction only being permitted to the extent the LTV would be at or below a certain level on a pro forma basis, after giving effect to that transaction. Any breach of the LTV covenant will require that the facility is repaid, or additional collateral (such as cash or liquid securities) posted as security, in order to reduce the LTV covenant to an acceptable level. Similarly, when investments are disposed of, the cash realized as a result will likely need to be applied as a mandatory prepayment against the facility, although the amount may vary depending on the applicable LTV level at the time.
The calculation methodology of the net asset value of the fund’s investments will largely depend on the nature of the underlying assets and the transaction dynamic, but often the NAV (or in a private equity context, the LP account value) as reported by the fund manager is used, at least as a starting point. Alternatively, the lender may require that it calculates the NAV itself, or a third-party valuation agent may be appointed. Generally, the lender will have the right to dispute a valuation and appoint its own value if it disagrees with the borrower’s calculation.
In a similar fashion to a subscription financing, lenders will apply eligibility criteria and concentration limits to determine whether the fund’s investments qualify to be lent against. Typical criteria for a private equity-style fund include that the relevant investment is not in default under its material contracts, is located within agreed jurisdictions, has not breached applicable sanctions laws, is not insolvent and so on. Often, significant discretion is afforded to the lender as to the decision of whether an investment is suitable to be lent against. In a private equity context, a NAV financing may typically require a minimum level of diversification of the underlying investments, such as a minimum number of investments (10, for example) at a basic level, as well as more nuanced requirements ensuring that investments are not overly concentrated in the same geographic region or business sector.
As well as an LTV covenant, lenders may also require a covenant testing the value of each investment to its acquisition cost, in order to provide protection against a reduction in the value of the borrower’s portfolio following the making of each investment.
For many lenders, NAV financings are only provided as part of a wider banking relationship with the borrower, alongside a subscription line and other banking solutions. The lender may undertake their own due diligence on the borrower’s investment portfolio in the course of its credit review, or alternatively may rely on a third-party valuation of those investments.
In terms of credit support for a NAV financing, security will likely be taken over the bank accounts into which distributions from the investments are paid and may also be taken over the underlying investments. In the context of a private equity fund borrower, this typically involves pledges over the shares in the holding companies which hold those underlying investments, as well as over the bank accounts into which distributions from those investments are paid. Issues may arise in this regard, principally in the private equity context, where existing third-party leverage will generally exist at the level of each individual investment (and those investment-level lenders will therefore be structurally senior to any fund-level leverage). The agreements documenting the investment-level financing will normally contain a requirement to prepay the facilities in full on the occurrence of a change of control of that investment. Whilst change of control-related issues on the grant of security can often be structured around, enforcing security over the shares in a holding company (and the resulting change of ownership) will in all likelihood trigger that mandatory prepayment requirement, and given that the fund-level lender is structurally subordinated to any investment-level lenders, the fund-level lender’s recovery will necessarily be net of the liabilities owed to the underlying lenders.
Since a NAV financing is credit profiled against the underlying assets of the fund, rather than its investors’ undrawn commitments, a NAV facility offers a financing solution to funds in the middle to later stages of its life, where a subscription financing might not be a viable option (assuming that the majority of the investors’ capital has been drawn down and deployed). Accordingly, the maturity of a NAV financing may be longer than for a subscription financing (and may exceed the length of the fund’s investment period). Conversely, a NAV financing may not be suitable for borrowers in the early stages of the fund’s life cycle, when undrawn commitments are high, but few investments have been made. Furthermore, as mentioned previously, since a NAV financing can be used to provide longer-term financing, the proceeds may be used to return capital to investors earlier than would otherwise be possible, thereby boosting the IRR of the fund.
In a further development in this area of the market, certain types of “hybrid” fund finance facilities have begun to emerge. At its core, a hybrid facility combines the upwards-looking nature of a subscription line with the downwards-looking element of a NAV financing, forming a single financing product which is credit profiled both against investors’ uncalled capital commitments, as well as the value of the fund’s underlying assets. Accordingly, this type of financing can be used as a “cradle-to-grave” financing solution for a fund, providing leverage in its early stages (when the fund has plenty of uncalled capital but few investments), through to the end of its life cycle (when the fund holds several investments and has deployed substantially all of its investors’ capital).
Co-invest facilities are another type of fund financing product which have also emerged into the fund finance arena in recent years. Although a co-invest financing is typically advanced to an “above-the-fund” entity, this type of facility is conceptually similar to a NAV financing in that it is also “downwards-looking”, credit profiled against the value of a co-investor’s interest in a fund, structured as a loan to that person to finance its capital commitment to the fund. Co-invest financings can therefore be used to leverage a co-investor’s return in its fund, or (if much of its commitment to the fund has already been advanced) to unlock capital to return to itself early, subject to compliance with restrictions in any of the fund’s partnership agreements to which it is subject.
The underlying borrower of a co-invest financing is often a high net worth individual with a prominent position within the fund manager, with the loan either being advanced directly to that person, or to one of the vehicles through which they co-invest in the fund (such as a general partner). Accordingly, co-invest financings are often used by lenders as a tool to build a private banking relationship with these high net worth individuals and to cross-sell products and services offered by other business areas of the lender.
Co-invest financings are usually, like a NAV financing, subject to a loan-to-value covenant. The key difference between the LTV covenant applicable to the two is that the test for a co-invest facility of course only takes into account the relevant investor’s share of the value of the underlying investments (i.e., the value of its specific interest in the fund), so requiring that the aggregate amount borrowed under the facility does not exceed a set percentage of the value of that fund interest.
This type of financing shares many similarities with a NAV financing, in that the LTV covenant will be tested on a regular basis, as well as in order to permit certain transactions such as asset disposals and distributions to investors. For example, when the fund returns capital to the general partner or co-invest vehicle, the LTV covenant will be tested in order to determine the proportion of those proceeds which is required to be applied in prepayment of the facility (although in many cases, all distributions received by the borrower are required to be used to prepay the facility prior to the investors receiving any further returns). Similarly, in terms of calculation of the value of the borrower’s interest in the underlying fund, the fund manager’s calculation of that value will often be used, at least as a starting point (and subject to the same sensitivities around dispute rights and third-party valuations mentioned above).
A co-invest financing will typically also be structured as a term facility rather than a revolving credit facility, given the usual use of proceeds of this type of facility. Conversely, given that the facility is effectively only credit profiled against one investment (the co-investor’s investment in the fund) rather than all of the fund’s investments, concepts such as eligibility criteria and concentration limits are usually not relevant for a co-invest facility. Instead, other controls become relevant, such as a “key man” provision which requires that the co-investor remains involved in the day-to-day operations of the fund – the lender is here relying to some extent on the reputation of the individual to which it is lending (and the name of the fund itself) to make prudent investment decisions, rather than having specific controls with regard to the types of investment which the fund can make.
As for a NAV financing, the key credit support for the lender in a co-invest financing comes from the value of the fund’s underlying investments (or here, co-investor’s share of that value). Accordingly, the lender will typically aim to take security over the borrower’s interests in the relevant fund documents (such as partnership agreements) to which it is a party. Security may also be taken over the ownership interests of the co-investor in the borrower vehicle itself (or, if different, the entity to which the distributions from the fund are paid), and its bank accounts, in order to ensure that distributions from the fund are swept up into the lender’s security net. Clearly, thorough due diligence is required in setting up this type of facility and its related collateral, since the fund documents may often restrict some or all of this security being taken (or indeed on the borrowing of the facility itself). However, many issues can be structured around with careful thought and advance planning.
Furthermore, in addition to asset-based security, lenders may require a personal guarantee of the facility to be granted by certain of the individuals co-investing in the fund through the borrower entity. This of course raises regulatory issues to be navigated and also produces tensions with other debt provided to those individuals, which can be significant in the context (such as large or multiple residential mortgage debts). Again, thorough due diligence is required to ensure that any potential issues are flushed out at an early stage.
To give further comfort as to the strength of the security package, the lender will typically require the co-investor(s) to comply with certain financial covenants, such as a minimum net worth covenant, or a requirement to maintain liquid assets (such as cash, cash equivalents and other liquid securities) with a minimum value in a securities account with the lender. This both protects the value of the lender’s security package in a downside scenario and also encourages an ongoing business relationship between the co-investors and the private banking arm of the lender.
Whilst subscription lines have been (and continue to be) a cornerstone of the fund financing space, recent years have seen the emergence of alternative financing products which seek to offer financing solutions in situations where a subscription line may be of limited or no value. Of the two products examined in this article, the NAV financing seeks to offer a permanent leverage solution to a fund in the middle to later stages of its life cycle, when much of its investors’ capital may have been deployed (therefore making a subscription line difficult to implement at the very least), whereas the co-invest financing allows individual co-investors to leverage their investments in the funds which they manage, whilst also providing lenders with an opportunity to build a closer private banking relationship with those high net worth individuals.
Although the credit profile of each of these two financing products is similar, looking down to the value of the underlying assets of the fund with a loan-to-value based test at its heart, each has a unique set of considerations and potential hurdles to be addressed, particularly in terms of restrictions in agreements to which the fund or its investments are subject and with respect to the eligibility and valuation of the assets which are to be financed against.