The market for net asset value (“NAV”) credit facilities continues to grow rapidly, with evolving features and mechanics. As the market matures, it brings new opportunities for both borrowers and lenders. Private investment funds and bank lenders are taking advantage of the various benefits that NAV credit facilities can offer. In this Legal Update, we explain the advantages of NAV credit facilities to lenders and borrower funds.
Characteristics of a NAV Credit Facility
A NAV credit facility is a term or revolving credit facility in which a lender provides financing to a fund, with the loan availability based on the net asset value of the fund’s portfolio of investments. NAV credit facilities are often used by private equity funds after the fund has matured beyond its investment period, when it has typically exhausted most of its investor capital commitments. After the investment period, funds generally cannot access borrowing availability under a subscription-backed credit facility because they do not have sufficient remaining uncalled capital commitments. With a subscription-backed credit facility unavailable, the fund may turn to a NAV credit facility to provide the liquidity necessary to manage its portfolio and investment activities.
In NAV credit facilities, the borrowing base is typically determined by applying an advance rate against a subset of the fund’s investment portfolio that are deemed to be eligible investments. To be an eligible investment, the investment must generally meet specific criteria for inclusion and not be subject to certain material investment events described in the facility. Such material investment events may include bankruptcy events, write off, or a significant decline in value. The value of eligible investments in the borrowing base may also be subject to concentration limits, such as sector limitations or thresholds for the ratio of individual investment size to the overall borrowing base.
NAV credit facilities also often include various loan-to-value (“LTV”) triggers, which can result in different consequences such as mandatory prepayments, cash sweep mechanics with respect to distributions, events of default or pricing adjustments if the LTV falls below a specific threshold.
Differences between NAV Credit Facilities and Subscription-Backed Credit Facilities
Unlike a subscription-backed credit facility, for which uncalled capital commitments of investors in the fund serve as collateral, the investments of the fund are viewed as the primary source of repayment in a NAV credit facility. Collateral in a NAV credit facility often includes pledges of equity in holding vehicles, rights to distributions, and collateral accounts; it does not typically require pledges of capital call rights and capital commitments. While the tenors of the NAV credit facilities can be flexible to suit a borrower’s needs, they are generally longer tenors than subscription-backed credit facilities and, subject to the needs of the fund, are more frequently structured as term loans rather than revolving loans.
The legal due diligence in connection with a subscription-backed credit facility will focus primarily on the investors and the fund’s organizational documents relating to the underlying capital commitments of investors to the fund and the obligations thereunder of the investors to respond to a capital call by a lender. For a NAV credit facility, legal due diligence focuses on the fund’s organizational documents and the ability of the fund to enter into the NAV credit facility and to pledge collateral. The legal due diligence will also focus on the ownership of the assets of the fund and the structure through which the fund holds portfolio investments. In many cases, the fund’s organizational documents have been drafted to expressly provide for a subscription-backed credit facility but may not necessarily contain express provisions relating to a NAV credit facility. Assuming the organizational documents generally permit the incurrence of indebtedness and the pledge of collateral that is otherwise contemplated by the NAV credit facility, any limitations on the incurrence of indebtedness and the pledge of collateral will be the primary focus of the legal due diligence of the fund’s organizational documents rather than the specific provisions typically required by a lender for a subscription-backed credit facility.
Benefits of NAV Credit Facilities to Funds
NAV credit facilities can provide several benefits to funds (including its sponsors and investors). Among them:
- Funds can unlock liquidity from typically illiquid assets and permit sponsors to optimize fund performance by increasing investment capacity to fund follow-on investments on the existing portfolio without the need to resort to traditional liquidity events, such as a public offering or other sale of a portfolio company.
- Funds can maintain liquidity and leverage options beyond the fund’s investment period when capital commitments may no longer be available to support a subscription-backed credit facility.
- Funds can leverage their assets even when they have challenging investor bases, such as a concentrated investor pool or investors that may not typically get favorable advance rates under a subscription-backed credit facility.
- The leverage provided by a NAV credit facility may allow the fund to utilize loan proceeds for dividend recapitalizations, which often isn’t permitted under a subscription-backed credit facility. A dividend recapitalization can also provide investors with an alternative to a secondary sale of their interests in the fund by receiving liquidity before the fund completes the sale of assets and allowing the investor to continue to participate in any potential increase in the fund’s value.
- Due to the enhanced margins of NAV credit facilities, private credit funds are attracted to the product. Insurance companies are also more willing to be a lender in a NAV credit facility as they are more often structured as term loans with longer tenors than subscription-backed credit facilities. As a result, the pool of leverage providers has expanded beyond traditional bank lenders that typically offer subscription-backed credit facilities.
- Sponsors can use a NAV credit facility in connection with its general partner stakes to efficiently manage its balance sheet or launch a new investment strategy by leveraging its management fees, carried interest or other income streams from the portfolio without the need for a liquidity event of its minority stake in the portfolio.
Benefits of NAV Credit Facilities to Lenders
Lenders can also benefit from entering into NAV credit facilities. Among the benefits to lenders:
- NAV credit facilities enable lenders to provide leverage to funds at all times, and of particular relevance to private equity funds, after the investment period with longer tenors, which may facilitate the expansion of the market of NAV lenders as they identify new clients for this product.
- NAV credit facilities provide a natural transition from a subscription-backed credit facility and allow lenders to maintain longer relationships with fund sponsors.
- The enhanced margins of NAV credit facilities, compared to subscription-backed credit facilities, may help facilitate the efficient use of capital for traditional lenders and provide an attractive investment opportunity to private credit funds.
- The pool of eligible borrowers may expand to include funds that have not participated in the subscription-backed credit facility market due to a challenging investor base or the hesitation of investors to authorize the fund to utilize subscription-backed credit facilities.
- Although NAV credit facilities can be complex, lenders can often be more creative in structuring the facility because the focus is not strictly on uncalled capital commitments.
NAV credit facilities and subscription-backed credit facilities are both useful tools in the fund finance market. NAV credit facilities may be a beneficial option for providing a fund with necessary liquidity and/or leverage in instances where a subscription-backed credit facility may not be an option for a fund. Sponsors can also obtain the liquidity necessary to effectively manage the fund and maximize its performance. Fund investors can also receive a return on capital without resorting to a sale and foregoing any potential additional upside from holding the investments longer. Lenders can also benefit from the attractive structuring and pricing options that NAV credit facilities present.