Private investment funds across all asset classes are increasingly taking advantage of net asset value (“NAV”) financing to improve fund returns or achieve other objectives. In a NAV financing, one or more bank(s) or alternative lender(s) provide a fund or one or more or its subsidiaries with a term or revolving credit facility, with borrowing availability based on the NAV of the fund’s investment portfolio. Once a closed-end private fund has matured beyond its commitment or investment period, it has typically called and deployed substantially all of its capital commitments to make investments. Accordingly, such funds often have little to no borrowing availability under any subscription credit facility. At that point, funds often turn to NAV financing. Investors in such funds are often supportive of NAV financing because it can potentially improve fund returns and give fund managers flexibility to manage the fund’s portfolio at a time when the fund likely has already called most or all of the investors’ capital commitments.
Reasons to Use NAV Financing
Funds use NAV financing to meet a variety of needs and achieve various objectives. Some of these needs and objectives are defensive (i.e., principal-protecting) and others are offensive (opportunistic, e.g., capitalizing on dislocated asset prices), and may vary depending on the fund strategy or asset class. Some funds use NAV financing for liquidity when other capital is not available on desirable terms, e.g., to fund capital expenditures in connection with the build-out of leased real property, follow-on investments in portfolio companies or ongoing maintenance and asset disposition expenses. Other funds may borrow against the value of the overall fund portfolio to prop up one or two underperforming investments (e.g., to cure a covenant breach at the level of portfolio company debt). Some funds may obtain NAV financing to refinance more expensive asset-level debt, when asset-level debt is not available. In addition, funds increasingly use NAV financing to tuck in one or two additional investments into the portfolio toward the end of the fund’s life to boost fund returns and performance. We have also seen funds using NAV facilities to accelerate distributions to investors in advance of an exit.
Selected Business Points/Considerations
The structure and terms of NAV financing (e.g., whether it is secured or unsecured, etc.) depend on various factors, including the structure of the fund and the type of investments it holds. NAV financing is available at varying price points depending on those factors, including the loan to value ratio, whether there are regular cash flows from investments, the type of investments, and more. In each NAV financing, there are often several highly negotiated business points/considerations, including:
- Collateral package. The collateral package is one of the most important points in a NAV financing transaction. Some established fund sponsors with funds investing in certain high-quality asset classes may be able to obtain unsecured NAV financing. However, most NAV financings are secured. From a lender standpoint, the purpose of the collateral package is not only to give the lender the ability to foreclose on and dispose of the fund’s asset portfolio in a default scenario, but also to ensure that, if necessary, the lender will be able to stop any distributions that the fund receives from the asset portfolio from being distributed to the fund’s investors before any mandatory repayments are made under the NAV financing (e.g. to maintain an specific LTV ratio). The collateral package may include: (i) distributions and liquidation proceeds from the fund’s investments, (ii) the right to receive such amounts, (iii) a pledge of the bank account into which such distributions are required to be paid (with a corresponding springing account control agreement to ensure that the lender can access the cash in a default scenario) and, sometimes and (iv) a pledge of equity interests in any entity holding (directly or indirectly) the investments. Whether or not the collateral package will include a pledge of equity interests will depend on any restrictions on such pledges in the documents governing the underlying investment and on how practical it is to obtain any required consents to such pledges. If the borrower under the NAV facility is an intermediate holding vehicle rather than the fund itself, the lenders may also require that the fund itself provide a guarantee of repayment. In a default scenario, the lender will be entitled to sweep the borrower’s cash, foreclose on/sell the pledged equity interests (if such pledge was in fact provided), and/or call on the fund guarantee, and then to apply the proceeds to repayment of the NAV financing.
- Loan to Value. Because borrowers under a NAV financing are either the fund or one or more holding entities immediately below the fund, any NAV financing is by definition structurally subordinated to the creditors at the level of any investment-specific debt (which may include portfolio company debt, typically at high leverage levels). Lenders get comfortable with the risk profile of NAV financings by advancing only a small percentage of the NAV of the fund, with the percentage varying depending on the nature of the underlying assets but often being in the 10-30% range. The maximum permitted LTV ratio is highly negotiated and a key metric of any NAV loan.
- Cash flow sweeps/Repayments. Typically, the lender and fund will negotiate the terms on which the fund will repay the NAV financing with cash flows (e.g., from dispositions of or income from investments).The percentage of cash flows that must be applied to repayments can range widely and may be applicable only at certain times while the financing is outstanding (e.g., if the fund fails to satisfy certain covenants with respect to the financed assets) or upon exit of a portfolio investment. The parties will also negotiate exceptions, e.g., permission to make necessary tax distributions to limited partners or to maintain REIT status where applicable.
- Minimum assets/diversity of the investment portfolio. While there are some lenders that specialize in lending against highly concentrated investment portfolios (sometimes, with only one investment), most lenders that provide NAV financing require a minimum number of assets and/or other diversity in the investment portfolio. For example, a lender may require that the fund always maintain  assets in the portfolio, with the failure to do so triggering mandatory prepayments or other negative consequences.A lender may also require that there be a certain amount of diversity in the investment portfolio, e.g., investments in portfolio companies in two or more different industries or markets.
Selected Legal Points/Considerations
The NAV financing market is still developing. These facilities tend to be highly bespoke in nature and so are the legal considerations that arise in these deals. However, legal considerations that arise frequently include:
- Collateral package. It’s worth reiterating that the collateral package for a NAV financing is often one of the most important, and highly negotiated, points in a NAV financing transaction. From a legal perspective, funds (and lenders) should note that the fund, organizational, and asset-level loan documents and agreements may have restrictions that prohibit the direct or indirect pledge or transfer (to a lender or its assignee in a default/remedies enforcement scenario) of some or all of the proposed collateral. Where there are pledged equity interests (including interests in other funds), legal counsel will need to review and confirm that the pledge of those interests is permitted by the underlying documents, to avoid the NAV financing inadvertently triggering a default, “change of control” or other issue. Additionally, pledges can raise tax issues and/or issues with respect to how to perfect the lender’s security interest, which are beyond the scope of this article.
- Flexibility. Since NAV financing is often entered into in the mid- to later-stages of a fund’s life cycle, fund sponsors may not be thinking about the need to build in flexibility for NAV financing in the fund’s limited partnership agreement toward the beginning of the fund’s life cycle (when those documents are often negotiated). While savvy managers have started to preemptively incorporate such flexibility in their new fund documents, it is often not the case that the flexibility exists in funds of older vintages, which generally do not contemplate leverage other than traditional subscription facilities. In our experience, fund sponsors will benefit most from working with experienced legal counsel (on fund formation as well as fund financing) and advisors that have experience with funds’ financing needs at all stages of their life cycle. Experienced legal counsel and advisors can ensure that the fund documents have sufficient flexibility to permit the NAV financing when and if the fund wants/needs it by ensuring, among other things, that debt limitations are not tied to uncalled capital commitment amounts (which would prevent a NAV financing after the fund’s uncalled capital has been depleted).
NAV facilities can be extremely useful, but also very complex. The market is just scratching the surface in terms of what is possible in NAV financing, with more sponsors looking to take advantage of this product and credit providers looking to enter the market every day. In this environment, understanding the facility’s collateral structure, the underlying assets and the fund document limitations is critical for setting up a successful transaction. With this in mind, fund sponsors benefit from working with financing advisors and law firms that are capable of comprehensively handling the fund’s needs, including the fund formation and financing needs at each level of the fund structure. Regardless, anyone advising a sponsor seeking NAV financing must work closely with fund formation and transaction counsel to ensure that the terms of the NAV financing do not create unanticipated issues elsewhere in the fund’s structure.
NAV financing can be a terrific tool for savvy fund sponsors to meet their needs and achieve various objectives, including obtaining liquidity, facilitating later-stage acquisitions, and improving investment returns. NAV financing is one of the most complex types of financing in the entire financing universe, raising numerous business and legal issues and considerations. Fund sponsors that are contemplating NAV financing, or that want to ensure that they have the flexibility to obtain it in the future, would be well served to work closely on these matters with experienced legal counsel and advisors.
About the Authors
Patricia C. Lynch is a Partner at global law firm Ropes & Gray LLP. Ms. Lynch works regularly with asset managers on NAV facilities, credit fund leverage facilities, subscription facilities and management company and GP financings.
Patricia Texeira is a Counsel at global law firm Ropes & Gray LLP. Ms. Teixeira is one of the senior members of the firm’s fund financing team and advises funds on all aspects of fund finance, including on credit fund leverage facilities and NAV financings for private equity funds.
Anastasia N. Kaup is a Managing Director and Partner at Fund Finance Partners, LLC. Fund Finance Partners is an independent advisory firm that advises fund sponsors on debt financing solutions (including NAV financing) to achieve their various objectives, including improving fund performance, operations, and profitability.
Stay Up To Date with Ropes & Gray
Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
Stay in the loop with all things Ropes & Gray, and find our more about our people, culture, initiatives and everything that’s happening.
We regularly notify our clients and contacts of significant legal developments, news, webinars and teleconferences that affect their industries.