The Advantages Of Net Asset Value Credit Facilities – Fund Finance

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.

Conclusion

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.

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Mayer Brown article provides information and comments on legal
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