On 25 July 2024 the Institutional Limited Partners Association ("ILPA"), the trade body for institutional limited partners in the private equity industry, issued its much anticipated Guidance for Limited Partners and General Partners in respect of NAV-based facilities (the "Guidance").
As a very brief re-cap, net asset value ("NAV") based facilities are credit facilities made available directly to a fund (or, more typically, to a holding company ("Holdco") immediately below the fund) which are backed by the value of the fund's investments. Lender recourse under a NAV facility is limited to those investments and their distributions and cashflows, typically by way of security over the shares in the Holdco and security over the account of the Holdco into which investment distributions and cashflows are paid. NAV facilities therefore cross-collateralise the equity of multiple portfolio companies of the fund (or, in the case of NAV facilities to private credit funds, the credit assets of the fund).
NAV facilities have been used by secondaries, real estate and private credit funds for some time but their adoption by private equity and infrastructure funds has noticeably increased in the last few years and has attracted increased scrutiny from limited partners ("LPs"), and some negative attention from the press, as a result. The Guidance only deals with NAV facilities utilised by private equity funds.
The Guidance focuses on LPs' concerns regarding NAV facilities (which often stem from a lack of understanding of, and familiarity with, the product rather than any specific issue with it) and (1) calls for improved transparency and greater disclosure from general partners ("GPs") around the usage of NAV facilities, (2) recommends that, going forward, funds' limited partnership agreements ("LPAs") contain specific parameters around NAV facility usage and a requirement for limited partner advisory committee ("LPAC") consent in certain circumstances, and (3) sets out standardised disclosures that ILPA recommends GPs deliver to their LPs once a NAV facility is put in place.
The key takeaway from the Guidance is that, whilst there might be a very good reason for the fund to utilise a NAV facility, in the absence of proper disclosure and transparency from GPs, LPs will draw their own conclusions as to the rationale (and that conclusion might well be a negative one and at odds with the reality). Increased transparency, disclosure and, where applicable, LP/LPAC consent rights should therefore benefit both LPs and GPs.
The Guidance
The Guidance is succinct and clear and covers five main areas:
- An overview of NAV facilities and current
market practices
- LP concerns regarding NAV facilities
- Recommendations for improved transparency and LP
engagement
- Proposed changes to legal documentation
- Recommended disclosures related to the use of NAV facilities
Key takeaways - LP concerns
ILPA outlines in the Guidance what it sees as being the main concerns among the LP community around NAV facilities, namely:
- Limited insight among LPs as to when NAV facilities are being used
- The lack of governance in the LPA around permitted usage of NAV facilities
- Concerns around a possible conflict of interest between GPs and LPs as to usage of NAV facilities
The first two points are linked. Many LPAs (particularly older LPAs) are silent as to the usage of NAV facilities – on the one hand, there is unlikely to be an express provision permitting NAV facilities and, on the other, there are typically no express restrictions on NAV facilities (LPAs will impose restrictions on fund-level leverage, but because NAV facilities are very often borrowed at an SPV or master holdco level directly below the fund, GPs have been able to interpret those leverage restrictions as not applying to the SPV / master holdco and therefore as not restricting NAV facilities.)
The conflict of interest point is a more interesting one and appears to be the key LP concern. The Guidance states that, because the uptick in usage of NAV facilities has coincided with very challenging fundraising and M&A markets, there is a concern among LPs – where NAV facility usage is not communicated to them by the GP – that NAV facilities are being used (whether explicitly or indirectly) to make distributions to LPs and thereby to artificially enhance the "Distributions to Paid in Capital" ratio ("DPI"). Both DPI and IRR will be improved by returning capital to LPs early and they are both important metrics by which a fund's performance is judged – there is therefore a concern among LPs that GPs could use NAV facilities to artificially inflate both DPI and IRR in order to encourage LPs to commit to their next fund. That LP concern is exacerbated by the cost of NAV facilities (particularly the ongoing interest expense) and the fact that any so-called "synthetic" distributions will very often be recallable. ILPA also notes that LPs are facing increasing questions and scrutiny from their own stakeholders, which can be difficult for these LPs to address in the absence of guidance and information.
Whilst ILPA's main concern appears to be where NAV facilities are used to fund distributions, the Guidance makes it clear that LPs also have concerns where NAV facilities are used to support the portfolio (e.g. to fund working capital and bolt-on acquisitions) – the main concerns being (1) that the fund has not retained sufficient capital reserves beyond the expiry of the investment period and is therefore being poorly managed and (2) a perceived risk that a GP that is struggling to fundraise might utilise a NAV facility to increase its assets under management under its existing fund (and therefore increase its management fees if the management fee is calculated on cost).
Key takeaways - Increased transparency and disclosure
The Guidance recommends that unless an LPA explicitly permits a NAV facility, that GPs seek LPAC consent to implement a NAV facility and disclose:
- The rationale and use of proceeds
- Size, structure and controls – e.g. the facility size, repayment requirements, security and any financial covenants
- Key economic terms
- LP obligations – including whether any distributions funded by a NAV facility would be recallable
The Guidance also recommends that where (as is often the case) an LPA is silent on the use of NAV facilities and where leverage restrictions under the LPA are expressed to apply to the fund only, that LPs proactively ask their GPs how they have interpreted those provisions and whether they view the leverage restrictions as applying to the fund only.
Going forward, the Guidance recommends that newer LPAs "address NAV-based facilities to ensure a shared set of expectations and guardrails around permissible uses" and include clearly defined limits as to the amount of leverage that a GP is able to incur through NAV facilities throughout the life of the fund. ILPA does not recommend any particular percentage or other limit on leverage, and considers that this should be set in the course of the usual fund negotiations "based on the strategy of the fund and relevant risk factors". It does, however, provide suggested language for LPA amendments to contemplate NAV facilities, and cautions generally against "broad authority to implement NAV-based facilities with little LPAC or broader LP oversight".
The Guidance also recommends that LPAs require GPs to seek LPAC and/or LP approval for all conflicts of interest associated with NAV facilities. Where a facility is to fund distributions, it recommends that LPAC consent be sought prior to that facility being put in place, regardless of whether the GP has received prior LPAC or LPA consent to use a NAV facility generally.
Finally, the Guidance includes a set of standardised disclosures about NAV facilities which it recommends GPs provide to their LPs once a NAV facility has been put in place, and a set of questions to guide LP dialogue with GPs.
What are we seeing?
The Guidance has been anticipated for some time and its focus on increased transparency and disclosure was widely expected and will, we suspect, be welcomed by GPs and LPs alike (if not necessarily by other players in the fund finance community who may question, for example, the need for specific LPAC or LP consent).
We suspect, for most funds, that concerns around NAV facility usage are overstated – for well managed GPs NAV facilities remain a very useful tool in the liquidity toolkit to realise maximise value from a fund's investments. Moreover, only a relatively small percentage of NAV facilities in the market are used to fund distributions so the particular concern around that usage seems overblown. There are also of course plenty of LPs in the market who are looking for liquidity and who welcome earlier distributions funded by NAV facilities, particularly given that any such distribution will be made at NAV (contrast with a sale by the LP of its interest in the secondary market, which would typically be made at a discount to NAV).
We have started to see NAV facility provisions built-in to new fund LPAs, particularly over the last six to twelve months, as well as more standardised due diligence requests from LPs on the intended use of any NAV facilities throughout the life of the fund. The Guidance is likely to accelerate that trend and we expect an increasing prevalence of NAV facility provisions in new fund LPAs as a result, with an increased role for LPs and LPACs before a NAV facility is put in place. How standardised those provisions become remains to be seen.
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