Providing leverage to funds, whether private equity, credit, real estate or hedge fund, or to funds of funds, has been an area of increased interest from secondary fund managers. There are two main ways for funds to finance themselves, either through subscription facilities or through NAV financing. We will explain each of these structures below and their main differences.
What are subscription facilities?
In the world of private equity, a manager raises money from investors (the limited partners or “LPs”) who commit a certain amount to a fund (the Limited Partnership). That money is then invested by the manager (the General Partner or “GP”) in various underlying companies. The commitment of the investor, however, is not funded at the time of its subscription, but rather will be funded as the capital is being called, on a need basis by the GP to make the investments it wants. To make those capital calls more efficient, the GP can set up what is called a subscription facility, with a traditional lender to smooth out the calling process. This facility is called a ‘look up’ structure, as it is secured by the uncalled contributions of the LPs.
As private equity has evolved, their needs have also evolved. These subscription facilities did not answer the financing needs of funds that were mature and had either called all the capital they were allowed to call, or had additional capital needs after their investment period. That is the need that secondary managers are answering via NAV lending facilities.
What are NAV lending facilities?
Unlike subscription lines backed by uncalled capital, NAV facilities are backed by the fund’s investments. The investments can be direct company investments or any assets the fund is invested in. So, for a fund of funds, the NAV facility will simply be backed by the LP interests in other funds (PE, credit, HF or any other asset class). The advantage of this facility is that it can be used either in the middle or at the end of a fund’s life, when all capital has already been called, but when a GP wants to increase investments in one of its underlying portfolio companies, make acquisitions, buy-back minority shareholders or simply hold on to assets longer while returning cash to LPs.
We often hear GPs being hesitant to use these facilities, mentioning that LPs have a negative view of them as they are viewed as leverage (at the fund level) upon leverage (at the investment level). However, the use of NAV financing has evolved since the COVID crisis started. Today, many high-quality GPs with high performing funds are using NAV-based fund facilities as an innovative way to add value to a quality portfolio. Originally used for a more defensive move (such as supporting a company in difficulty or in transition, without new equity or fund working capital for pivots where equity would normally be required), it is now regularly used as an offensive tool, allowing a company to make acquisitions or expand. GPs also look at NAV financing as flexible, bespoke capital that can be used to create value in any number of ways. In addition to being used opportunistically for acquisitions, GPs can use NAV financing to lower cost of capital, versus traditional mezzanine financing or to stretch LP dry powder. Loans can be cross-collateralised with a pool of assets securing the loan, and the lender can allow flexibility to take assets out of the pool as the GP borrows against its fund NAV rather than the uncalled capital. Lastly, GPs have used this source of capital to provide liquidity to investors by accelerating distributions to LPs, thereby improving distribution to paid-in (DPI), or to repay sponsor shareholder loans. Going forward, we expect that NAV financing will continue to evolve as GPs become more accustomed to using structured liquidity solutions to finance their fund’s needs.
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