Transfer Restrictions in NAV Credit Facilities: Impact on Collateral and Market Solutions
Executive Summary
A common hurdle in Net Asset Value (NAV) credit facilities is the presence of transfer restrictions on equity interests. In this Legal Update, we explain how these transfer restrictions operate in NAV credit facilities, their practical implications, and potential solutions for navigating their complexities.
Background: Transfer Restrictions Limit Pledges of Equity
Transfer-restriction provisions purport to prohibit—or require—consent for any transfer or pledge of an equity interest in a portfolio company, or treat even an indirect change in control or indirect pledge of an equity interest as a restricted transfer, including scenarios where the fund pledges its interests in holding vehicles or an aggregator vehicle, which may impact the borrower’s pledge of equity interests as collateral.
In practical terms, if a lender attempts to take a security interest in such equity without the requisite consent, the pledge may violate the restriction. Upon default under the NAV facility, the lender may be required to obtain additional consents to realize the expected value of that collateral, effectively becoming blocked from foreclosing or selling the interest due to the restriction or be limited to a pledge of the economic interests relating to such equity. In short, asset-level transfer restrictions can place practical limitations on the collateral package available to a lender.
Diligence Challenges in Large Collateral Pools
Although it would be preferable for NAV lenders to review all applicable documents to determine the scope of transfer restrictions and the consequences of disregarding such restrictions, doing so may be impractical. For deals with many underlying investments, reviewing all applicable documentation for transfer restrictions can be time-consuming and costly. Among other things, the relevant investment documents in a particular deal are not necessarily uniform, so there may be inconsistent limitations on equity transfers and unique consequences to such transfers within the documents. To diligence all of them could require combing through hundreds of documents—a complex and potentially time-consuming exercise.
Because thoroughly verifying each asset’s status is often deemed impractical for a large portfolio, some lenders are willing to consider more streamlined collateral structures to avoid the up-front effort of chasing down consents or waivers. Lenders may also choose to rely on a borrower’s representation that either no restrictions exist or, if such restrictions exist, that they have received appropriate consents. Additionally, lenders may require a borrower to use commercially reasonable efforts to obtain any required consents after a default or other triggering event (such as a loan-to-value decline). Finally, some lenders will proceed with a limited review and accept the residual risks, but doing so creates market uncertainty.
Potential Solutions
Limiting Collateral to Distributions
One potential solution is to forego taking a security interest in the equity interests. Instead, the lender receives two more narrow forms of collateral: first, a pledge of the right to receive distributions (if a transfer restriction does not prohibit such a pledge) and second, a covenant in the loan documents requiring the borrower to deposit all distributions into a pledged deposit account, coupled with a security interest over the bank accounts into which those distributions are paid. Because this structure—often referred to as “security lite”—gives the lender recourse to the assets’ economic proceeds without technically “transferring” any equity, it continues to gain traction (including among traditional bank lenders) as a way to avoid the transfer restriction issue entirely.
However, this structure does come with trade-offs. Since the lender’s collateral is limited to distribution accounts, lenders rely heavily on financial covenants and cash-sweep mechanisms to ensure they can ultimately realize on the value of the underlying investment portfolio. Lenders typically impose strict loan-to-value thresholds and cash-trap triggers. If performance deteriorates, they may sweep all net proceeds. Lenders may also require diversification covenants to maintain a broad asset base. Importantly, enforcement rights are narrower; the lender can sweep cash but has no direct control of the assets themselves. If a default occurs, the lender must obtain repayment through distributions as and when they occur, or must pursue the borrower as an unsecured creditor for recourse beyond the accounts.
The market has recognized these limitations, and lenders are often only comfortable using this structure when the assets are generating reliable distributions and robust covenants are in place. Even then, this approach is less robust than a traditional equity pledge, and it requires careful structuring to mitigate risks.
Compromise: Pledge of All Permitted Equity
Given the drawbacks of the “security-lite” approach described above, where diligence of each relevant investment document is impractical, some NAV lenders have adopted practical compromises. One such compromise is to take a pledge of all equity interests except interests subject to a valid transfer restriction that would prohibit such a pledge. In other words, the lender’s collateral package includes all equity interests for the entire portfolio of investments but excludes those assets subject to a transfer restriction.
This collateral approach is often paired with a covenant requiring the borrower to use good-faith efforts to obtain waivers of transfer restrictions in a foreclosure scenario, and/or requirements to maintain a certain proportion of assets that have been reviewed to confirm they are not “excluded.” Rather than exhaustively confirming each asset’s status, the facility is structured so that any asset with a transfer restriction that could impair a pledge is automatically carved out of the collateral. If an investment is, in fact, subject to a transfer restriction and no consent has been obtained, that particular equity interest falls outside the collateral definition by operation of the carve-out. The lender still holds security in all other assets and can fall back on indirect protections with respect to the “excluded asset” (such as negative covenants or reliance on distribution rights). Additionally, Lenders can use “all-asset” UCC filings to put third parties on notice of the claimed security interest, even where the scope of the collateral is limited by these exclusions.
This approach spares the parties from an extensive diligence exercise on day one, reduces costs, and streamlines execution time. Additionally, this structure aligns with the commercial understanding between the borrower and the lender: that the fund’s NAV—and, by extension, the equity value of its investments—is the core collateral backing the facility. Under this compromise, the lender gets as close to a full equity collateral package as commercially possible, which aligns with the business understanding that they are lending against the value of those holdings.
Notably, while this provides the lender with additional collateral compared to the prior approach, many lenders may still underwrite these facilities as if transfer restrictions will apply (in case they ultimately cannot rely on the equity interests). In some circumstances, this middle-ground solution can strike the right balance between legal prudence and business practicality, acknowledging the reality of potential transfer restrictions without foregoing potential collateral that would make a NAV facility viable.
Bottom Line for Lenders
Transfer restrictions are common in NAV deals and need not be a deal-breaker for NAV facilities, but they do require thoughtful structuring. It may be costly or time-consuming to obtain consents for a deal that would otherwise require several equity pledges and such a deal could get bogged down. Structures with less credit support (such as pure distribution-only security) can reduce lenders’ security interests. Lenders and borrowers seeking a compromise may consider pledging all permitted equity interests (as described above) to mitigate diligence costs and keep deals moving. At the same time, this compromise maintains an important component of the lender’s credit support—the NAV of the fund’s investments—within the collateral package. We are seeing this solution used more often by lenders and borrowers in larger NAV lending transactions to balance credit support with execution efficiency—two priorities that increasingly drive NAV facility design and pricing.
