19 June 2023 - As the United States turns the page on the COVID-19 crisis, it suddenly finds itself facing a new predicament relating to the liquidity and solvency of a small number of its regional banks.
Though crises cause upheaval, they often catalyze the spread of technological, cultural or financial innovation. An example of the latter is a little-known institutional financial product which has increasingly gained industry acceptance: the Net Asset Value (NAV) credit facility.
A NAV facility is most often a loan to an alternative investment fund that is secured by the fund’s investments. Collectively comprised of its Net Asset Value, such investments may consist of private equity, venture capital, infrastructure, credit, real estate or holdings in other investment funds.
Why do these funds seek to borrow? Typically, they desire flexibility to deploy additional capital after the commitments from their investors have been exhausted. This may be due to an unforeseen extreme event (such as a pandemic, or a banking crisis), requiring them to play defense and support existing investments – alternatively, they may seek to take advantage of a lucrative follow-on investment opportunity.
As central banks worldwide have tightened financial conditions, capital markets as well as banks have followed their lead, reducing both the volume and pricing of asset sales. Indeed, PitchBook estimates the exit (sale of assets) to investment ratio for private equity firms hit a 10-year low in 2022 as investors continue to find new opportunities or refuse to exit at valuations they deem too low1. As a result, private equity and other alternative investment funds have been seeking other avenues to generate liquidity – and chief among these are NAV facilities.
A NAV loan may also be used when institutional investors seek incremental leverage on their Limited Partnership (LP) holdings in alternative funds. Typically, the institutional investor submits a subset of their alternative investment holdings to a lender as collateral for a NAV loan, thus creating liquidity. Historically, institutional investors have tended to use this type of loan in order to generate liquidity when the cash flow from their LP portfolio is expected to slow. At times, institutional investors have also used NAV loans in lieu of a sale of assets on the secondary market, allowing them to avoid having to book a potential loss. By using the NAV loan for interim liquidity, the investor may later realize the assets in an orderly manner over time.
Lenders who extend NAV facilities include banks, insurance companies and specialty private lenders. The Fund Finance Association – a non-profit industry association in the fund finance market – estimates the current size of NAV facilities globally to be less than $100Bn, which represents well under 1% of the estimated value of private capital investments. 17Capital, a private lender, projects the NAV market to grow to $700Bn by 20302.
The innovation behind NAV facilities
NAV lenders tend to be conservative in their structuring and underwriting, and rely on several features of the facilities to protect themselves.
First and foremost, NAV facilities are low leverage, usually between 5% and 25% of the fund’s value. By looking at historical data, including investment performance during and after the great financial crisis (GFC), lenders size facilities with a requisite margin of safety to ensure the borrower can withstand a severe systemic downturn.
Second, unlike a leveraged loan to a company sponsored by a private equity firm, a NAV facility’s collateral consists of a diversified pool of investments, typically a dozen or more individual positions. This diversification protects the lender against idiosyncratic shocks at the portfolio level.
Third, the NAV loan is fully committed by the lender at closing, and maturity of the facility is typically matched with the expected liquidation timeframe of the underlying assets. Unlike products such as repo loans, which engage in maturity transformation, there is little risk of a “run on the bank”.
Lastly, these facilities benefit from a structural alignment of interests: both the fund sponsor (the asset manager) and its investors are fully subordinated to the NAV lender in priority of payment. For an asset manager to continue its main business of raising future capital, it would be disastrous to default on a NAV facility. Though private equity managers are notoriously clever game theorists when dealing with lenders, every manager understands that fundraising is a repeated game. Similarly, the fund borrower shares an alignment with the lender in that a default would create a number of structural and reputational issues for its investors.
For these reasons, NAV loans are an innovation which can increase financial stability, acting as a safety net for alternative funds, allowing them to generate liquidity without selling assets at inopportune values. Meanwhile, capital providers benefit from stable funding and low Loan-To-Value (LTVs) ratio, and are thus able to act in a countercyclical manner, improving the resilience of their borrowers.
The historical evidence is also encouraging: during the GFC, NAV facilities were primarily used for fund-of-funds – investment vehicles that pool capital and invest in underlying strategies managed by third-parties. Unlike leveraged loans, high-yield bonds or residential mortgages, NAV facilities enjoyed favorable credit outcomes during the crisis, with minimal defaults and losses.
This is why further growth in NAV lending is likely from here. They offer alternative asset managers a prudently structured solution, providing liquidity and helping the manager fulfill its fiduciary duty to its investor clients. For lenders, they provide a secure, low loan-to-value credit structure with a diversified collateral pool and favorable alignment of interests. Systemically, these facilities serve as an important source of stability for alternative investment vehicles, facilitating the efficient allocation of capital which underpins the global economy.
1 PitchBook, ‘Q3 2022, US PE Breakdown’, page 16
2 17Capital, ‘NAV Lending – the emerging opportunity for Private Debt Investors’, page 10-11