The outbreak of the current novel coronavirus (also known as COVID-19) has caused significant and wide-ranging disruptions to business and economic activity worldwide. These disruptions have similarly impacted global financial markets and financial reporting. By most accounts, the fund finance markets have seen increased activity notwithstanding (or because of) COVID-19 in the first months of 2020.1 While the long-term impacts of COVID-19 on global financial markets are unknown, there are a few immediate issues that are likely to be relevant in the short-term for the fund finance markets.
By the time closed-end private investment funds (each, a “Fund”) have matured beyond their investment or commitment periods, they have typically called and deployed a majority of their uncalled capital commitments to acquire a portfolio of investments. As a result, such Funds often have diminished or non-existent borrowing availability under the borrowing base of a traditional subscription-backed credit facility (a “Subscription Facility”). Certain banks and other non-traditional financial institutions, including certain private credit Funds (in each case for purposes hereunder, a “Lender”), recognizing that a fully-invested Fund has inherent value in its investment portfolio, extend credit to such Funds primarily based on the net-asset-value (“NAV”) of a Fund’s investment portfolio (an “NAV Credit Facility”). While NAV Credit Facilities may have multiple Lenders (or are structured to permit multiple Lenders), they are often bilateral facilities, allowing the single Lender and the Fund the latitude necessary to negotiate and address the many challenges resulting from COVID-19.
It is important to note, that notwithstanding the potential challenges created by COVID-19, fund finance market participants continue to express substantial interest in NAV Credit Facilities. Many Funds and Lenders have conveyed to Mayer Brown that opportunities may be available for new NAV Credit Facilities due to these market disruptions. As evidence of such optimism, a number of sponsors have recently launched new Funds that have a market-event-driven investment strategy and an NAV Credit Facility may be an attractive option to both Funds and Lenders to capitalize on new opportunities. As a result of the increased interest in NAV Credit Facilities, it will be vital for both Funds and Lenders to understand key features unique to NAV Credit Facilities and how COVID-19 disruptions will require both Funds and Lenders to find creative solutions to meet the challenges discussed in this market update.
One of the primary challenges in an NAV Credit Facility is the calculation of the NAV of each portfolio investment held by the Fund (each, an “Investment”), particularly with respect to illiquid Investments with no readily available mark-to-market valuations. The borrowing base in an NAV Credit Facility is based upon the NAV of the applicable Investments, and obtaining current and accurate valuations with respect to such Investments is critical for both the Fund and the Lender in order to determine the borrowing base, compliance with financial covenants and for the Lender to properly evaluate and manage its risk and exposure.2 This market update will highlight a few near-term considerations for NAV Credit Facilities related to the valuation of Investments and other issues surrounding the COVID-19 financial market disruptions.
II. NAV Credit Facilities Generally
The terms and structure of an NAV Credit Facility will largely be determined by the structure of the Fund and the nature of its Investments. Parties to NAV Credit Facilities, however, all share similar concerns related to the timely and accurate valuation of the NAV of each Investment for purposes of calculating the borrowing base. Borrowing base availability under an NAV Credit Facility is traditionally an amount equal to the “Eligible NAV” of the “Eligible Investments,” multiplied by an agreed advance rate. The “Eligible NAV” typically equals the NAV of the “Eligible Investments,” as reduced by any applicable concentration limits agreed to by the parties. Note that concentration limits may be a critical structuring point for a Fund that seeks an NAV Credit Facility with a small or non-diverse pool of Investments, and fluctuations in the value of such Investments may increase the likelihood of triggering such concentration limits due to a limited amount of “Eligible Investments” contributing to the borrowing base. These concentration limits will vary in each NAV Credit Facility, but may include limits on the amount of NAV included in the borrowing base attributable to the largest Investment as a percentage of the overall borrowing base or other limitations on the percentage of the borrowing base derived from a particular industry or investment strategy. The “Eligible Investments” are Investments held by the Fund that meet certain pre-defined criteria, which may include the ability of the Lender to exercise discretion in designating an Investment as an Eligible Investment. Such an Investment will lose Eligible Investment status if any of the relevant criteria are no longer satisfied or if other adverse credit events related to such an Eligible Investment occur. For example, standard eligibility criteria for Investments of a private equity Fund will require that the underlying portfolio company not be in bankruptcy or in breach of any of its material contractual obligations. With respect to a debt Fund that has Investments comprised of debt instruments issued by one or more third-party issuers, the status of the debt instrument itself as a performing asset and the credit status of the issuer of such a debt instrument are often eligibility criteria for inclusion of such an Investment in the borrowing base. The advance rates for NAV Credit Facilities are typically low in comparison to Subscription Facilities and other asset-based facilities, reflecting the lack of immediate liquidity, valuation and disposition concerns, a likely more limited collateral package, and potentially uncertain cash-flows of such Investments.3
Calculating the NAV of the Eligible Investments is a critical component of determining the borrowing base in NAV Credit Facilities. A Fund will typically include valuation procedures in its organizational or offering documents (which valuation procedures are typically consented to by the Fund’s investors as part of their initial capital commitment to the Fund), which may include regular third-party valuations of the Investments in addition to regular audit reports. Notwithstanding these valuation procedures, a Lender may negotiate the ability to revalue the Investments for purposes of determining the borrowing base if the Lender disagrees with the valuation provided by the Fund, even if the valuation is conducted in compliance with the Fund’s stated valuation procedures. Additionally, if certain adverse credit events occur with respect to an Investment, a Lender may also have the ability to require an independent valuation of all or a portion of the Investments. A Lender may therefore require a third-party valuation process or even the ability of the Lender itself to revalue the Investments based on its own good faith judgment. The Fund and the Lender may also agree in advance to a list of approved third-party valuation firms that will conduct such independent valuations.
Reporting the NAV of the Eligible Investments is typically done no less frequently than quarterly. Timing of Investment valuations can be another challenge because there is frequently a gap between the time a valuation is completed and the reporting date with respect to such a valuation. In order to mitigate risks related to this timing gap, Lenders will often require reporting covenants with respect to interim adverse credit events. The reporting that a Lender will receive from a Fund in connection with an NAV Credit Facility, however, is not limited to reporting on the Investments but will also include standard financial reporting with respect to the Fund itself. Annual audited financial statements and quarterly financial statements will be delivered to the Lender as well as other reporting delivered to investors in the Fund.
The valuation of Investments in an NAV Credit Facility and the calculation of the borrowing base can be a complex endeavor under normal circumstances, but the unique disruptions to financial markets and regular reporting caused by COVID-19 discussed below may require Funds and Lenders to utilize often rarely used valuation procedures outlined in an NAV Credit Facility meant to address significant declines in value or divergent valuations.
III. COVID-19 Impact
The stay-at-home conditions unleashed across the globe in response to COVID-19 have shuttered businesses deemed non-essential and otherwise severely curtailed the normal operation of most economies. It is expected that COVID-19 will ripple through every layer of the economy and revenues may be significantly reduced, if not altogether eliminated, for many businesses in the short-term and are difficult to forecast, based upon traditional or historical models, in the medium and long term. The impact of COVID-19 on a Fund’s portfolio companies may interrupt the previously forecast cash-flow or realization potential of the Fund’s investment, or even result in a bankruptcy event with respect to such portfolio companies if the impact is severe. For debt instruments held by a Fund, the issuer may default on payments as a result of lost revenue or other market disruptions, or similarly experience a bankruptcy event. Real estate holdings may be unable to collect full rent payments or may otherwise experience a decline in sale prices or have realization opportunities evaporate altogether. Regardless of the Investment held by a Fund, COVID-19 introduces some degree of uncertainty into the valuation of such an asset. This uncertainty may be even more significant for a Lender that is further removed from the Investment and depending on the Investment, may not have the same experience in valuing the asset as the Fund, even under normal circumstances. COVID-19 may further exacerbate the discrepancy in valuations that a Fund, a Lender, the sponsor of the Investment or a third-party may produce with respect to any given Investment.
As a result of these valuation uncertainties, COVID-19 market disruptions may have impacts on minimum NAV covenants, borrowing capacity, concentration limits, mandatory prepayments and Eligible Investment criteria under an NAV Credit Facility. Since the value of Eligible Investments determines the borrowing base in an NAV Credit Facility, declines in the NAV may trigger a mandatory prepayment of outstanding loans if the value of those Eligible Investments has declined in an amount that no longer supports the amount of outstanding loans. The impact of COVID-19 on the market for Investments may additionally impair the ability of the Fund to make any resulting mandatory prepayment. The Eligible Investment criteria may also have triggers that could potentially completely remove an Investment as an Eligible Investment (as opposed to simply reducing the borrowing base value of such Investment) due to a significant decline in value.
Additionally, if certain Investments suffer a decline in value in an amount that is disproportionate to other Investments comprising the Eligible Investments, even those Investments that have not suffered a decline in value may now be valued in excess of concentration limits imposed on the borrowing base (e.g., the second largest Investment in the portfolio becomes subject to a concentration limit imposed on the largest Investment in the portfolio due to a decline in value of the formerly largest Investment), thus diminishing the value such Investments may otherwise contribute to the borrowing base. The impact of concentration limits on the calculation of the borrowing base may result in a mandatory prepayment. In addition to a borrowing base, an NAV Credit Facility may also include a minimum NAV covenant with respect to the Fund itself, which may be triggered if enough of the Fund’s Investments suffer a significant decline in value. A breach of a minimum NAV covenant would typically result in an event of default under an NAV Credit Facility. As a result of any of these decline in value events, a Fund may need to infuse additional equity or sell assets to repay all or a portion of an NAV Credit Facility. Either of these remedies may prove challenging for a Fund in the shadow of COVID-19.
Although not included in every NAV Credit Facility, valuation dispute resolution mechanisms are a potential tool that a Lender may use to challenge the reported NAV of an Investment. If an NAV Credit Facility has such a valuation dispute resolution mechanism and the NAV of an Investment has declined by an amount in excess of a certain percentage compared to the most recently reported NAV or a Lender believes the asset should have declined in value more than the reported NAV, a Lender may have the ability to request a third-party valuation of such an Investment. In other instances, an NAV Credit Facility that includes a valuation dispute resolution mechanism may permit a Lender to request a third-party valuation of any Investment at any time (subject in some cases to limits on the number of valuations per year or other similar limitations). How such third-party reported valuations are used under the terms of an NAV Credit Facility that include a valuation dispute resolution mechanism will vary, but the options typically range from averaging such third-party valuation of an Investment with the Fund’s reported NAV, using the third-party valuation only if such value is more than a certain pre-determined percentage difference from the Fund’s reported NAV, or otherwise relying on such third-party valuation as the replacement NAV of the Investment. NAV Credit Facilities with valuation dispute resolution mechanisms are likely to see an increased focus on and questions related to such third-party valuations in the near future due to COVID-19 financial market disruptions.
Another consequence of COVID-19 financial market disruptions that may impact NAV Credit Facilities is a potential increase in modifications to material agreements related to Investments. The assets held by a debt Fund, for instance, are derivatives of underlying debt instruments that have documentation governing the issuance of such debt by the issuer thereof. These issuers may request modifications of such debt instruments in order to accommodate waivers, consents and amendments in response to COVID-19 impacts with respect to the covenants applicable to such an issuer. An NAV Credit Facility will often have restrictions on the Fund permitting certain modifications of those underlying documents. Funds may likely seek Lender approval to make such modifications with more frequency due to COVID-19. Lenders in turn will be tasked with determining if such modifications will have an impact on the expected value of such assets and the ripple effect on the NAV Credit Facility.
While it remains to be seen, disruptions related to COVID-19 may also potentially delay financial reporting generally or, in some cases, raise questions regarding the accuracy of reporting with respect to certain Investments given the rapid impact of COVID-19 on markets generally. Due to the fact that auditors are likely unable to conduct on-site audits during stay-at-home orders, the audited financial statements that Funds are required to deliver in connection with an NAV Credit Facility may be delayed in some instances, but this is not likely to occur on a wide-spread basis.4 Asset-level reporting may also be delayed due to similar limitations related to the ability to conduct on-site inspections or properly assess value. In each instance, potentially delayed reporting will require Funds and Lenders to work together to either amend or waive certain reporting requirements under an NAV Credit Facility. Delayed reporting may further complicate the ability of a Lender to determine whether minimum NAV covenants have been triggered or to properly value Eligible Investments in the borrowing base.
Notwithstanding the challenges presented by COVID-19 to the financial markets, NAV Credit Facilities continue to be a reliable leverage option that Funds may use to take advantage of opportunities presented by current market conditions. The short-term impact of COVID-19 on NAV Credit Facilities will most likely center on declines in Investment values, third-party valuations and reporting delays. While financial markets adjust to COVID-19 disruptions, Funds and Lenders will need to familiarize themselves with and understand the nuances of their respective rights related to valuations and reporting in NAV Credit Facilities. Much like previous financial market disruptions, both Funds and Lenders will undoubtedly be faced with unique challenges and need to explore creative solutions to maintain productive partnerships. Experienced legal counsel can help guide this analysis and suggest how best to navigate the landscape created by COVID-19 to both address short-term challenges and capitalize on long-term opportunities.
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1 For a detailed update on current trends and developments in the fund finance market as a result of COVID-19, please see Mayer Brown’s Fund Finance Market Update: Fund Finance in the Era of COVID-19, available at www.mayerbrown.com.
2 Note that certain NAV Credit Facilities may rely primarily on financial covenants applicable to the Fund (e.g., liquidity, leverage ratios or minimum overall NAV) in lieu of (or in addition to) a traditional borrowing base that is determined by the NAV of individual Investments. While the focus of this market update is borrowing base focused NAV Credit Facilities, the topics discussed here are equally applicable to financial covenant focused NAV Credit Facilities.
3 The collateral in an NAV Credit Facility is often times limited to a distribution/collection account that receives proceeds from the Investments due to restrictions on pledging the underlying Investments themselves.
4 Guidance from the Financial Reporting Council regarding audit issues arising from COVID-19 has unequivocally stated that there should be no deviation from the audit standards that apply in normal circumstances notwithstanding the challenges presented by the pandemic. For a more detailed examination of the impact of COVID-19 on audits, please see Mayer Brown’s Auditors: Risk management in the face of COVID-19, available at www.mayerbrown.com.