The Rising Tide of NAV Facilities
Fund finance, the practice of lending to investment funds, is experiencing a significant transformation with the increasing prominence of Net Asset Value (“NAV”) credit facilities. NAV facilities are credit facilities that have availabilities that are based on the net asset value of a fund’s underlying investments. These facilities can have a variety of collateral packages, ranging from a direct lien on the underlying investments, to just being limited to the right to receive distributions and the associated bank accounts, and/or a pledge of the equity interests of the entities that hold the investments.
Secondaries funds (funds that invest in interests in other funds) and especially private credit funds (funds that invest in loans to private companies, which are often backed by private equity funds) have long utilized NAV facilities. However, certain key factors have driven the expansion of NAV facilities into use by private equity and other funds, including the liquidity crunch.
NAVigating a Liquidity Crisis
Today, funds are facing an unprecedented challenge in generating liquidity. This is in contrast to the pre-COVID era, during which the market enjoyed explosive growth of subscription credit facilities as they became a near-universal part of a fund’s capital structure. These facilities—secured by unfunded capital commitments of investors, the general partner’s right to call capital, and the enforcement of those rights—are attractive to lenders due to their extremely low default rates and perceived safety as a product. However, due to the failure of several large participants in the subscription lending market during the banking crisis of 2023, the exit or retreat of other large participants from a significant presence in the market, and tighter capital requirements required by the proposed BASEL III endgame regulatory changes, demand for subscription lines currently outstrips supply.
In addition to the decline in the supply of subscription facilities, today’s challenging market conditions have constrained other traditional sources of liquidity as well. Today, private equity funds are facing the slowest private M&A and IPO market in decades, which has significantly slowed the pace of asset disposition. The lack of exit opportunities is also causing many funds to be cautious in calling capital from limited partners, who have expressed that they are facing their own liquidity crisis due to inflation, geopolitical uncertainty, high interest rates, and the denominator effect (i.e., overweighting of private equity assets as part of an institutional investor’s entire portfolio). The lack of distributions has also contributed to the slowdown in new fundraising opportunities to these same limited partners.
NAV facilities allow the fund to navigate this liquidity challenge by enabling distributions to investors and serve a number of other important purposes, including acquiring new investments, supporting existing investments, and providing working capital. NAV facilities permit the fund managers to continue operating the fund with the view of maximizing the investor return, and avoid the premature and possibly discounted dispositions of assets that may otherwise be required.
Structured Finance Meets NAV Facilities
Today, a private equity fund seeking a NAV facility can access a market of providers familiar with the product and willing to compete for their business. In recent years, as the discourse on these NAV facilities to private equity and other funds has continued, the pool of providers has significantly expanded,[1] in particular to include insurance companies that are seeking highly rated debt products with an attractive yield. The resulting competition has led to a significant compression of pricing on these NAV facilities, which has further driven up demand and has made the product more accessible to a broader set of managers and funds. At the same time, the addition of insurance companies as new entrants has meant that structures and techniques that facilitate the obtaining of a rating, which were long used in the structured finance market, are gaining ground in fund finance. NAV facilities across various asset classes are increasingly structured using independent credit ratings, tranching, bankruptcy-remote special purpose vehicles, true sale, and non-consolidation techniques.
This mirrors the development that has already undertaken in regular-way NAV facilities in the private credit space, which has already seen a widespread adoption of these techniques to assist in decoupling the creditworthiness of the fund’s assets from that of the fund or sponsor, leading to lower pricing and access to a wider range of financing sources. A similar dynamic is found in the rise of collateralized fund obligations (“CFOs”), a form of securitization of underlying investment fund assets. Typically, the fund interests are transferred to a holding company held by the CFO issuer, which issues both debt (notes) and equity interests, backed by the payments and distributions received by the underlying fund interests.
It remains to be seen whether the high interest from insurance companies in NAV facilities to private funds will be sustained. In particular, the National Association of Insurance Commissioners (“NAIC”) has been actively reviewing the regulatory oversight of private equity and complex assets within the insurance industry. In particular, the NAIC has adopted amendments to statutory accounting reporting requirements to state that CFOs and similar private funds–associated products may no longer automatically be given the regulatory treatment that they were typically given (as “bonds”).
Practical Considerations
Both lenders and fund managers entering the NAV facility space should ensure they have competent advice from counsel familiar with these complicated transactions and the internal infrastructure to implement and maintain these facilities. The initial structuring of these facilities requires a deep understanding of the tax and regulatory considerations for all parties. Asset transfers and pledges require significant diligence and coordinated execution. Maintaining the facilities and associated vehicles as separate from the original owner requires discipline and investor education. Lastly, NAV facilities may require compliance with additional regulatory regimes, including the securitization regulations adopted in the EU and the UK and the asset-backed security and associated risk retention requirements in the US.
In addition, fund managers should be aware of recent discourse on NAV facilities generally. In particular, the Institutional Limited Partners Association (“ILPA”) has recently provided guidance regarding the use of NAV facilities, in particular when the proceeds are used to make distributions to limited partners because such distributions can potentially impact fund performance calculations and the limited partner’s ability to allocate capital. ILPA recommends greater communication between GPs and LPs regarding the use of NAV facilities, and many major NAV lenders note that the vast majority of their NAV facilities are not used for distributions, but rather add-on investments or refinancings of pre-existing debt to the portfolio at a lower cost of capital than might otherwise be available.
The Future of Fund Finance
NAV facilities represent a significant evolution in fund finance, offering new opportunities for both funds and lenders. As the market evolves, it is crucial for participants to gain a thorough understanding of these facilities, including their structures, applications, and potential risks. For fund managers and lenders aiming to navigate economic challenges and seize opportunities, a deep knowledge of these tools—such as fund manager constraints and the motivations of various investor groups—will be essential for creating flexible capital structures and optimizing outcomes in a rapidly changing market. Even though the rise of NAV facilities has been in part driven by the current liquidity crisis and the challenges of the subscription facility market, we expect this market to continue to grow even after these broader market conditions pass, as lenders recognize the attractiveness of the product and fund managers understand NAV facilities to be an additional tool in managing their portfolios and find a broader spectrum of lenders willing to offer the product.
This evolving trend is a key focus of the Fund Finance/Asset Based Lending Subcommittee of the ABA Business Law Section, and this article is based on presentations and discussions by that subcommittee, including those by the Authors and other members of the Subcommittee, including Elizabeth Tabas (Chair of the Subcommittee) of Sidley Austin LLP, Leah Edelboim of Cadwalader, Wickersham and Taft LLP, and Linda Filardi of Flagstar Bank.
