Travers Smith's Alternative Insights: NAV lending to private equity funds

A regular briefing for the alternative asset management industry.

Despite last year's blip, investor interest in private markets remains strong. McKinsey's 2024 Global Markets Review reports that a majority of LPs plan to maintain or increase allocations to the asset class over the medium to long term, and assets under management have grown nearly 20% p.a. since 2018. Against the backdrop of that rapid growth, and in light of ongoing innovations by GPs, it is clearly important that investors work together to establish best practice standards and increase their collective sophistication.

The Institutional Limited Partners Association (ILPA) plays a key role in that respect – and it continues to be busy. Having updated its guidance on continuation funds last May, and while it continues to review its highly impactful reporting template, ILPA issued much anticipated guidance on NAV-based facilities in July.

So-called NAV lending, where credit is made available directly to a fund – or, more typically, to a holding company immediately below the fund – backed by the value of the fund's investments, has certainly risen. Although these facilities have been used by secondaries, real estate and private credit funds for some time, their adoption by private equity and infrastructure funds has noticeably increased in recent years. In June, the Bank of England took note of them in its Financial Stability Report, saying that "the NAV financing market globally is estimated to be around US$100 billion and is expected to grow further over the coming years". The UK's FCA asked a number of private capital managers to report on their use of NAV facilities as part of the private market questionnaire that it circulated in July.

As the BVCA pointed out in its engagement with the Bank, NAV facilities remain a small part of the market, representing less than 1% of the value of private equity investments globally, and have conservative loan to value ratios. Still, some investors worry that they cross-collateralise the equity of multiple portfolio companies of the fund, increasing risk. Others are wary of their use to accelerate distributions to investors before the underlying companies are realised, but more comfortable if they are to facilitate follow on funding for an existing portfolio company – as was often the case during the pandemic.

        
    
"ILPA's characteristically constructive and open engagement with the investor and sponsor community continues to help the asset class to mature."

The ILPA Guidance, the result of extensive consultation among industry participants, focuses on their use by private equity funds, and concentrates on the need for dialogue, transparency and the management of conflicts of interest.

As ILPA points out, most limited partnership agreements don’t mention NAV facilities, and in many cases their use is effectively unrestricted. Some LPs worry that they are not being told about or consulted on usage of a NAV facility. And when NAV loans are used to finance accelerated distributions, there are also concerns that they enhance the fund's IRR and DPI (the ratio of distributions to paid in capital), making the fund's performance look better than the underlying fundamentals warrant.

To address these concerns, ILPA recommends that – unless NAV facilities are expressly permitted in the fund's partnership agreement – GPs seek consent from the LPAC (the Limited Partner Advisory Committee) before putting one in place. In seeking consent, the GP should give detailed information about the proposed facility, including what the proceeds will be used for.

The Guidance also recommends that, going forward, the limited partnership agreement (LPA) should specially "address NAV-based facilities to ensure a shared set of expectations and guardrails around permissible uses". Such guardrails would include clearly defined limits as to the amount of leverage that a GP can incur through NAV facilities during the life of the fund, but ILPA does not stipulate any recommended leverage limit. The Guidance also recommends that LPAs require GPs to seek LPAC and/or LP approval for all conflicts of interest associated with NAV facilities, and specific LPAC consent where a NAV facility is used to fund distributions.

ILPA's characteristically constructive and open engagement with the investor and sponsor community continues to help the asset class to mature. The Guidance is helpful for GPs and LPs alike, in part because it acknowledges that NAV facilities "can be a useful tool for capital structuring or to provide financing to support assets", to some extent combatting a more negative narrative that has evolved. Although sponsors will inevitably have quibbles about specific aspects – the role of the LPAC, for example – the focus on dialogue and transparency is welcome. Indeed, ILPA's intervention will accelerate an existing trend: some GPs have already started to deal explicitly with NAV facilities in their LPAs, and many LPs ask about them during due diligence.

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