NAV finance: an introduction

Subscription line financing is now a well-established and useful tool in the armoury available to an investment fund. It can bridge short term financing needs, allowing funds to move quickly in relation to successful bids for investments, and also ensure that the day to day costs of running the fund are not dependent on a stream of small drawdowns from investors. Subscription line financing is secured against the contractual obligations of investors to fund their undrawn capital commitments, sometimes described as “looking up” recourse. It is a feature of subscription line financing that the lenders are agnostic as to the asset class of the fund: it could be private equity, real estate, infrastructure, private credit, secondaries or any other asset class.

In contrast, net asset value (NAV) financing “looks down” to the portfolio of investments acquired by a fund. The term “net asset value” comes from the fact that the investments of private equity, real estate or infrastructure funds often also have individual asset level leverage, and the pool of investments that is relevant for a NAV financing is the net value after deducting the leverage for each investment. But NAV financing is also the term frequently used for financing provided to other kinds of fund such as secondaries funds or private credit funds which do not usually have asset level leverage. NAV financing for a credit fund is also sometimes referred to as ABL financing. Unlike subscription line financing, the lenders of NAV facilities are very focussed on the asset class of the fund, and certain lenders will only lend to certain asset classes of funds.

Whilst NAV financing has been around for a while, there has been a noticeable increase in completed NAV transactions since the start of the COVID pandemic, both in Europe and the U.S. At the start of the pandemic macroeconomic uncertainty contributed to the reticence of funds sponsors to call capital from their investors, leading those sponsors to seek liquidity from elsewhere for their investments. Following the end of the pandemic, the global uncertainty in economic markets and inflationary pressures resulted in balance sheet constraints available for subscription line financing for many banks. In addition, certain types of investors must receive distributions from investments in existing funds before they can commit to new funds (the so-called “denominator effect”). Cumulatively, all this has meant that fund raising for newly formed funds was lower in 2023 than it was in 2021 and 2022.

As a result of both the pandemic and the following global economic uncertainty the availability of and need for subscription line financing has reduced, producing a knock-on effect with the demand for NAV financing increasing. NAV financing can be an attractive source of liquidity for end-of-life or near end-of-life funds that have called and deployed all or a significant portion of their investors’ capital commitments but which now have an established portfolio of investments which continue to require capital investment.

Alternative lenders (such as credit funds) are attracted to the higher returns available from providing NAV financing, together with the fact the loans under NAV facilities are typically drawn for longer periods of time compared with loans under subscription line facilities. In addition, some banks in the fund finance market that historically provided only subscription line financing are now also branching out and offering NAV.

Although different types of funds may utilise NAV facilities, and use them for different purposes, the key characteristics are that they are generally provided at the fund level or directly below the fund level, and the primary source of repayment is from the underlying investments. They will be structurally subordinated to senior leverage financing, so in some ways structurally similar to mezzanine financ-ing. However, NAV facilities usually have recourse against the cashflows of all or a multitude of the underlying investments, whereas mezzanine facilities usually only have recourse to a single underlying investment.

The following paragraphs provide some of the key details of how NAV financing to the different asset classes of funds is structured.

Private equity (PE) funds will have a somewhat illiquid portfolio of perhaps only 10–20 investments. The security arrangements for NAV borrowing by PE funds varies. Some PE NAV lenders are comfortable with security only over the bank accounts of the fund into which investment proceeds flow on the disposal of investments, with an agreed regime for investment disposal on enforcement. Other PE NAV lenders require security over the shares of each individual holding companies that own an investment as well as bank account security.

Real estate and infrastructure funds will often also have individual asset level leverage finance in place. The security structure for these NAV financ-ings usually includes holding company share security and bank account security but may also include direct mortgages over underlying real estate or infrastructure assets. Direct asset level security is less common as it will compete with the leverage finance security at each individual asset and intercreditor discussions will be required. NAV facilities to real estate and infrastructure funds are often provided by the teams at banks who have traditionally provided leverage finance against individual assets. These teams already have a good understanding of the underlying assets individually, so it is a small step for them to understand the risks and rewards of providing portfolio-wide NAV financ-ing against multiple real estate or infrastructure investments.

Secondary funds that acquire and hold limited partnership in underlying funds can borrow secured against those limited partnership interests, although limited partnership interests almost always require consent of the underlying fund before they can be transferred on enforcement. This means that on an enforcement the NAV lenders often cannot quickly transfer the limited partnership interests to a third party purchaser, resulting in likely longer times to recover the full amount borrowed.

Direct lending funds and credit funds that acquire and hold loans and other debt instruments may enter into NAV facilities (also called ABL facilities) and provide security over the underlying loan portfolio, the bank accounts into which loan repayments are made and often also over the shares in the subsidiary company which is the lender of record for the loans held by the fund. On enforcement, the portfolio of loans can be sold as a whole, or alternatively the shares in the subsidiary company holding the portfolio can be sold.

A key factor in determining an appropriate security structure will be the due diligence carried out in relation to the underlying investments in the portfolio. The asset class concerned will set the parameters for the diligence exercise. For a PE fund with (say) 12 or 15 investments, relatively detailed diligence will usually be carried out into each investment to determine things like drag and tag rights for co-investors, change of control provisions, and whether the consent of any related party is required for an enforcement sale. For a credit fund, on the other hand, with (say) 200 underlying loans, diligenc-ing every loan is unlikely to be cost efficient and so only a sample of loans may be reviewed, to confirm matters like transfer restrictions.

The key financial covenant in NAV facilities is the LTV covenant. This is the financial ratio of the amount of the financial indebtedness of the borrower against the NAV of the investment portfolio that will be securing the facility. Depending on the asset class and the diversification of the underlying investments, LTV ratios can range from 10% to as high as 60% - or higher. NAV facilities may include a “LTV grid” that allows the borrower to benefit from higher LTV ratios, and therefore a higher facility amount provided by the lender in the event that more investments are included in the portfolio. Likewise, the interest rate payable on the facility may also decrease if the LTV decreases, and vice versa. Some NAV facilities also include cash sweep (or increased cash sweep) provisions based on a LTV grid.

Closely linked to the LTV covenant calculation is the valuation of the portfolio of investments. The start-ing point for valuations is the valuation prepared by the fund for its investors, usually quarterly, in the normal course of its investor reporting. The next point is what rights the NAV lenders have to challenge those valuations, and potentially seek an independent second valuation. Such alternative valuations are usually included in NAV facilities, but the variables are when the lenders can use them (a set number of times a year, and/or based on publicly reported events) and who pays for them (usually the borrower if the alternative valuation is lower than a specified percentage lower than the fund valuation, but otherwise the lenders). The valuation challenge provisions are always the subject of extensive negotiation.

When structuring a NAV-facility to a German PE fund or to one of its subsidiaries the pronouncement of the German Ministry of Finance on the income tax treatment of PE- and VC-funds needs to be considered. The pronouncement distinguishes between trading PE funds and asset managing (i.e., non-trad-ing) PE funds. Such distinction is important for in Germany resident partners in PE funds as the qualification of the fund as trading or non-trading determines the tax rate at which their individual income from the fund will be taxed. If the PE fund is qualified as a so-called trading partnership, then this will typically lead to a high tax burden of the individual partners making the respective fund investment unattractive. It is, thus, typically in the interest of the partners and the sponsors of a PE fund to ensure that the PE fund is not qualified as a trading partnership. As the taxation on the partner-level is concerned, the pronouncement is also relevant to PE funds established outside of Germany but with investors and/or sponsors (entitled to carried interest) resident in Germany.

According to the pronouncement it forms an indication for a PE fund being a trading partnership if it takes out loans on the fund-level. There are few exemptions to such ”no loan on the fund-level”-rule, but those do not include NAV-facilities. It is, thus, important for partners resident in Germany that a NAV-facility is not taken out by the fund itself. One solution to this issue is that the NAV-financing is provided by way of equity rather than by a loan. The provider of the NAV-financing receives an equity interest in the fund entitling to preferred distributions. One issue of such structure is that the fund documents often do not provide for preferred equity interests. As a result, approval of all partners needs to be sought which sometimes cannot be obtained or is not desirable from the fund sponsors’ perspective. In addition, NAV-financings by way of preferred equity interests are more expensive for the funds than normal NAV-facilities. Alternatively, the NAV facility can be granted to a subsidiary of the PE fund (a “finco”) as this as such does not form an indication for a trading partnership. This solution is also the preferred approach for most providers of NAV-financings as this is a structure, they are used to in their home countries. However, also in such structure certain issues need to be considered. E.g., if the PE fund grants security over its directly held assets (ie, the shares in the finco) or grants a guarantee for the loan of its subsidiary, then this also indicates a trading partnership under the pronouncement. One possible way to avoid this could be to include a double subsidiary chain beneath the PE fund, ie a holdco directly beneath the PE fund, and the finco beneath the holdco, which would allow the holdco (not the PE fund) to give security over the finco shares. Despite those specific German structuring issues NAV-facilities remain an interesting financing tool also for German PE funds.

In summary, NAV facilities have increased in use and demand significantly since the start of the COVID pandemic, are used by multiple asset classes of fund, are provided by a wider range of different lenders and vary in terms of structure and recourse. But they are definitely here to stay.