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Patricia Teixeira: Hi, my name is Patricia Teixeira, and I’m a counsel in Ropes & Gray’s finance group, specializing in fund finance transactions. Here with me today is Anastasia Kaup, managing director and partner at Fund Finance Partners, an independent advisory firm that advises fund sponsors on debt financing solutions, including NAV financing. Anastasia is also a former Ropes colleague and the co-chair of the Fund Finance Association Diversity in Fund Finance Committee. Ropes & Gray partnered with Anastasia and Fund Finance Partners last fall to write an article about what we were seeing at the time in the market with respect to NAV facilities. Back then, we mentioned how this was still a market in its very early stages, with generally very bespoke terms, and everything seemed customizable to the particular transaction and the specific needs of the sponsor. Fast forward 10 months, and there is not one week that goes by where we don’t get an inbound question from a sponsor or another market participant looking to learn more about this product. So, we thought it was time to reconnect to see how the market has developed in the last year or so.
Anastasia, to get us started, can you describe in broad strokes what we mean when we refer to NAV facilities, and some reasons a sponsor might consider adding it to its portfolio?
Anastasia Kaup: Sure, Patricia, and thank you so much for having me. A NAV, or a net asset value credit facility, is one that looks to either the underlying investments of a fund or other investment vehicle and/or the cash flows, distributions or other amounts received on account of those investments as the main collateral and/or basis for the credit facility. To draw a distinction to another popular product that sponsors use and are likely more familiar with, a subscription credit facility, there, instead of looking down toward the assets and cash flows from those assets, in a subscription credit facility, by contrast, you look up to the uncalled capital commitments of the investors in the fund or investment vehicle. Additionally, aside from the difference in collateral packages and structures, there are differences in the NAV market. There are both term and revolving NAV facilities. There are different negotiating points, different focuses and underwriting points for the credit facility providers and sponsors.
NAV credit facilities are used both for what we call “defensive” and “offensive” reasons. Some of those reasons that sponsors might consider using NAV financing—and we are increasingly seeing sponsors use NAV financing—include injecting liquidity into existing portfolio companies, add-on acquisitions, distributions, and commitment-period acquisitions to fill in fundraising gaps and/or to tuck in another asset prior to the expiration of the commitment period. So, it’s really still quite a bespoke, quite customizable, flexible product. We have seen an extraordinary increase in interest in the product, particularly from private equity fund sponsors, and believe that within a few years, nearly every fund sponsor—private equity, growth and buyout especially—will be using this product strategically to improve returns and achieve some of these other objectives.
Patricia Teixeira: Thanks, Anastasia. You just mentioned growth you have seen in the market, which matches our experience. I think two things that we have observed from the sponsors’ perspective that might explain at least in part such growth are: one, that sponsors are holding assets for longer periods of time, which often means the need for, as you mentioned, additional liquidity to see an asset through a rough patch or to wait until better exit opportunities materialize and, two—somewhat related to the first point—is that sponsors are often in the market raising their next fund before they have returned capital to their LPs from prior vintage funds, so there is some pressure to generate liquidity to return capital to investors. Can you speak to where the market is today in terms of size and participants, where you see the potential for growth, and any thoughts on what’s fueling such growth?
Anastasia Kaup: Sure. There has really been exponential growth in the NAV market. I think just in the past year, we’ve probably seen half a dozen new large and/or “serious” lenders/participants entering the market. Let me take a step back. So, there are bank and alternative NAV lending markets. Traditional depository banks, some of them have NAV lending desks. There are also the predominant portion of the market, the alternative NAV lenders—these include private credit funds who lend to other funds. And they’re very different markets—it’s hard to overstate that point. They have different loan-to-value (or LTV) ranges that they lend in. Some require scheduled amortization and/or cash sweeps. They have different interest rate spreads and different fees, including ticking fees on delayed draws. For example, it can be cheaper for an alternative lender that just raised a fund and can reserve capital for a longer period of time, versus another alternative lender that may not be in that position. MOIC and make-wholes are among other differences. It’s really apples and oranges. We make it our business to have info on where every lender is at in terms of balance sheet, where they’re at in their fund cycle if it’s an alternative lender, terms, appetite, etc. So, new lenders have been entering the market to close the gap on supply and demand as savvy sponsors pick up on how beneficial NAV financing can be. Other factors for this growth include that we’re in a high interest rate environment, making it harder to raise debt at a portfolio company level. The market has been maturing, so investors are more familiar with the product and are more accepting of it. They see it as a good use of net asset value, for example, to avoid the fire sale or less advantageous exit of an asset maybe at an inopportune time in the market. And because it’s a product where the sponsor is borrowing against the value of NAV in a portfolio that it has built, the investors tend to be much more supportive than, say, some investors are with respect to subscription financing.
Patricia Teixeira: Let’s talk about the typical collateral package in NAV facilities. The borrower on the NAV facility is either the fund itself or one or more holding companies below the fund. From the lenders’ perspective, as they are looking at the assets of the fund for repayment—as opposed to, as you mentioned, the uncalled commitments from funds’ investors in a traditional capital call subscription facility—lenders need to get comfortable that the assets they are relying on for repayment are usually highly leveraged at the portfolio company level already. So, how do lenders think about this structural subordination, the collateral package, and ways in which they can protect themselves in a downturn scenario? I’m sure you alluded to it already, but different lenders think about collateral packages differently, if you’re thinking traditional banks versus alternative lenders.
Anastasia Kaup: Banks and credit funds think of collateral packages differently, and it’s in part because traditional banks are more accustomed to underwriting “all assets” liens. And so, bank NAV lenders are often looking for a pledge of equity interest, perhaps in the intermediate holding company, and/or some kind of fund level recourse if they’re lending to a subsidiary holding company or SPV. Alternative lenders have been able to get comfortable sometimes lending just based on the cash flows coming out from the assets with no equity pledge at all. The lenders’ position in the capital structure and based on the collateral package, it all ties together and relates to the loan-to-value, what the sponsor can and is willing to pledge, and the lenders’ position in the capital structure. Most lenders in this space understand that many, especially private equity sponsors and portfolios, have asset-level leverage, and are able to get comfortable that there’s enough net asset value that even after repayment of any portfolio company debt, that they would be able to recover on the loan that they’re making, the NAV financing. Additionally, there are secured, unsecured and preferred equity options in this space, but the purpose of the collateral is really protection in an enforcement or downside scenario, and the ability to control distributions or get some of that cash coming out from the portfolio is what the lenders are looking for.
It’s also worth mentioning that private equity funds, in particular, in the equity ownership or organizational documents and/or the asset-level financing documents, there are often restrictions on pledges, whether direct or indirect, and often a need for some kind of consent to permit the NAV financing. And so, sponsors will want to work with capable, experienced, knowledgeable counsel and advisors to make sure that when they’re installing NAV financing and agreeing to a collateral package that they can actually give the lender what they anticipate they can give the lender. Structuring facilities and doing that sort of diligence is something that we specialize in and do up front, and I know the Ropes team is very capable at assisting sponsors with that sort of diligence from the legal perspective, as well.
Patricia Teixeira: This discussion on the collateral package is a great segue to my next point, which I want to touch a little bit on, the cash sweeps and the repayment mechanics, which, in my experience, is one provision that gets heavily negotiated in any NAV facility, because it directly impacts how quickly the lender will get repaid and how much flexibility the sponsor has to retain—and potentially distribute—a portion of the investment returns while the facility is still outstanding. Can you talk a little bit about the different ways the sweep mechanics can be set up, and I’m sure I know the answer to this, but generally the differences you see, depending on the type of asset and lender?
Anastasia Kaup: Yes, absolutely. And you’re so right—this is one of the key provisions and negotiating topics in these credit facilities. There’s a lot of nuance here, depending on a variety of factors. For example, sometimes lenders will only sweep cash from the “core” or most valuable, say, three to four assets, but not the rest. Sweeps can vary depending on the loan-to-value, the number of assets, whether the fund still has unfunded capital commitments in excess of any subscription credit facility obligations there may be, and things often ratchet up when you get down to a certain number of assets. A well-diversified pool or portfolio will have a larger cushion. Bank sweeps for NAV lending can be tighter than alternative lenders would impose. You won’t often see a well-diversified NAV loan that has a sale of an asset for which at least a portion of it can be swept by the bank. One of the most important things to note in this context is that if a sponsor can successfully structure cash sweeps to not interrupt their recyclable capital or recallable capital ability, they can really potentially expand the fund size if they can avoid the sweeps on recallable capital. We’ve had a lot of success structuring NAV financing for sponsors to do that.
Additionally, I would note that sponsors with leverage (in the negotiating sense) can often negotiate carve-outs from sweep requirements in advance. So, for example, if a sponsor anticipates that an asset exit is going to come up, say, within the next year, and they’re putting in place the NAV financing, they can negotiate to ensure that they or their LPs are able to receive distributions from that planned or anticipated asset exit during that first year of the NAV credit facility. Also, proceeds that are required to be swept versus everything in excess of a maximum loan-to-value can sometimes be retained, but it largely depends on, to sum up, the diversity of the portfolio, the performance of the portfolio, and loan-to-value. You’ll see with less diversity or with more of a struggle on performance, the cash sweep requirements often ratchet up because the lenders’ “cushion,” protection and what they’re looking to in terms of repayment is reduced in those situations. So, it makes sense that they would want to sweep more cash to get repaid if there’s any kind of lack of diversity or distress with the portfolio.
Patricia Teixeira: This all makes a lot of sense. So, I’m switching gears again a little bit, and as we all personally experienced earlier this year, a lot has happened in the fund finance market. I think market participants are still absorbing the impact of somewhat limited supply in the traditional subscription facility market. I know that our sponsor clients are getting used to the new normal in terms of interest rates and other terms on the sub-line market. Can you speak to what impact, if any, the collapse of the three original banks in the U.S. earlier this year had in the fund finance market as a whole, and in the NAV market in particular?
Anastasia Kaup: Sure. It’s worth noting that, in addition to what happened with the three banks, prior to that, banks’ balance sheets were constrained, in part because of capital retention and regulatory provisions that went into effect within the last, say, year or two. So, some of the factors impacting both the subscription market and, relatedly, the NAV market, are those balance sheet constraints. Also, some alternative lenders have available capital constraints. The market is still really working to figure out the supply/demand imbalance. We’ve seen in relatively recent months, pricing on subscription lines have generally gone up, along with greater demand/reduced supply. There’s been some scarcity of subscription leverage and difficulty for fund sponsors getting what they need, and whether it’s an emerging manager to the largest sponsors, some banks have been bringing down the limits on relationships or on products that they’re requiring. And so, the scarcity of the subscription leverage market has been leading to a greater need for NAV financing and a greater interest from sponsors, because that market is not as similarly constrained to the subscription lending market. Generally, spreads have been going up, advance rates have been going down, lenders have become a bit more conservative, but there is something acute and specific to the subscription lending market, such that there’s more of a need. We anticipate the market will figure itself out, so to speak, and we’ve already seen signs of that even within the last few weeks. Accordingly, it’s been impacting the NAV market, but we think the trend and the greater need and desire for NAV financing is only going to continue, even after things stabilize with the subscription lending market, because it’s such an advantageous product for sponsors, and such a broad and flexible product.
Patricia Teixeira: Yes, I agree. If anything, I think the current environment is a positive for NAV facilities to develop and for anyone interested in entering this market as a NAV lender. Certainly, NAV facilities are in everyone’s mind. Earlier this summer, in the European Fund Finance Symposium, there were at least two panels fully dedicated to NAV, but the topics seemed to make an appearance at every other conversation, too. One interesting point of discussion, then, was whether the structural considerations that were initially considered, like, hurdles to put a NAV facility in place, are still a hurdle to be overcome. A consensus seemed to be that the market has worked through these and generally came up with ways to structure around them. What are your thoughts on this? And in your experience, is fund documentation in general becoming more flexible to allow for NAV facilities in the future? I think one thing that is somewhat related that we face is the question of how limited partners are thinking about the use of NAV, and if their thinking has evolved in the last years in respect to that. Then, if you have any final thoughts or predictions on where this market is going, also, please share.
Anastasia Kaup: To take the broader market point first, Janet Yellen’s comments—I think it was earlier this summer—lead us to believe that we are not done with consolidation in the regional bank market, and more compression on top-tier lenders, a greater need for insurance capital, etc. We’ve been working with more insurance companies and rating agencies recently, working with our clients to get ratings on portfolios to obtain greater lending availability for our clients’ asset managers at a lower cost of capital. So, there’s been more entrants, but the market seems to recognize the greater need, and different parties are stepping up to fill that need at different price points. All of these factors that we’ve discussed are leading to liquidity shortages for funds and sponsors—meaning, there’s more of a need now than ever for NAV financing. It’s worth reiterating structuring can make or break a NAV facility, and it is critical to get it right before the parties get too far down the road. We typically do a deep dive and analysis into the fund documents and the entire situation, and advise our clients on feasibility and likely terms they’re going to get in the market. We have hundreds of data points on these facilities, and we know where all the lenders are at, but structuring, especially early on, how that facility is put together is critical to success. I would also note, on the structuring point, there are numerous workable structures to take into account tax and other considerations. If sponsors are thinking, “I have a very complicated structure. We have tax considerations. How are we going to put NAV financing in place?” we’ve pretty much been able to advise sponsors and get NAV financing in place for nearly every structure you can imagine.
You asked about how LPs are thinking about the product. We’ve had a great deal of success coming up with creative structures that satisfy both the four corners of the fund documents, as well as the LPs or LPACs. As I stated, LPs seem to be very supportive overall because NAV financing is a product that the sponsor obtains based on the value of the portfolio that they have built, as opposed to using the uncalled LPs’ capital commitments instead of calling their capital. NAV financing can often be used later in the stages in a fund’s life after there are no uncalled equity capital commitments remaining, maybe after portfolio company financing is tapped out, or it would be more advantageous to obtain NAV financing or on better terms than portfolio company financing. So, I think LPs are seeing the benefits and seeing the rationales for it—it’s improving funds returns, liquidity situations, all of the benefits we spoke about earlier.
Final predictions on where the market is going: We think within a few years, every savvy fund sponsor, particularly in private equity, will be using NAV financing. Many of them already are, and it seems to be a competitive advantage that’s really making a difference—this manager’s in this quartile versus that quartile, and one of the difference makers could be NAV financing. We think that’s going to continue even after, hopefully, the subscription lending market stabilizes.
Patricia Teixeira: Thank you so much, Anastasia, for joining me today for this interesting conversation. And thank you to our listeners. For more information on fund financing for private investment funds, including NAV facilities, please don’t hesitate to contact one of us or visit our website at ropesgray.com. You can also subscribe and listen to other Ropes & Gray podcasts wherever you regularly listen to your podcasts, including Apple, Google and Spotify. Thanks again for listening.