EXECUTIVE SUMMARY
Net Asset Value ("NAV") credit facilities are lending arrangements underwritten on the borrower's portfolio of investments, where the amount available for borrowing is based on the value of such underlying portfolio investments. The borrowing base may be calculated based on the net value of the borrower—its total assets minus total liabilities—or it may comprise a selected subset of eligible assets. The determination of the borrowing base depends on the borrower's reported value of its investments, which may originate from the sponsor or borrower's reporting, a third-party appraiser, the third-party sponsor issuing the investment, or a purchase or market value (in the case of publicly available marks). Because the reported value may come from the borrower and not an impartial source, lenders may require a periodic third-party valuation or the right to challenge the borrower's valuation by obtaining a third-party appraisal of some or all relevant investments included in the borrowing base. This Legal Update explores the scope and mechanics of asset valuation challenges, focusing on what lenders and borrowers need to consider when framing and negotiating provisions for valuation challenges in credit facility documentation.
BACKGROUND
NAV facilities are credit facilities underwritten by reference to the borrower's investments, such as equity interests in portfolio or holding companies, securities, and other investment assets. For this reason, NAV facilities typically have financial covenants, mandatory prepayments, and events of default tied to the valuation of these assets.
Effective underwriting of NAV facilities requires that asset valuations of investments (and often the assets that underlie those investments) are both current and accurate. To this end, borrowers are required to provide audited annual financial statements along with quarterly financial statements and compliance certificates, which certify the net asset value, loan-to-value ratios, and borrowing base calculations. Additionally, NAV facilities may mandate additional monthly or quarterly reporting requirements that provide specific details on the assets comprising the borrowing base, ensuring lenders have comprehensive reporting of the current value of investments.
WHAT NAV FACILITY LENDERS AND BORROWERS NEED TO KNOW ABOUT VALUATION CHALLENGES
SCOPE AND MECHANICS OF VALUATION CHALLENGES
Lenders often negotiate valuation challenge rights in transactions where the underlying assets are not otherwise subject to an annual third-party valuation or validation per the fund's partnership agreement or if the investments are illiquid and lack a readily available market valuation.
When lenders negotiate the right to challenge the reported value of the borrower's assets, they may negotiate the ability to do so on a regular basis and/or upon the occurrence of certain triggering events. For example, if a lender believes the value of an asset pool or an individual asset is overstated based on a periodic valuation provided by the borrower, the lender may negotiate the right to initiate a valuation challenge. Similarly, certain triggering events (such as a bankruptcy of an investment's sponsor or a default on debt and/or foreclosure on liens at the underlying investment or asset) could occur between regular reporting periods, and if so, lenders could require a revaluation to ensure the reported values remain accurate and reflect current market conditions.
These rights are important for lenders whose underwriting standards require adjustment of asset valuations in response to material changes, especially for certain assets where reporting can lag behind the reporting date, due to certifications not being due until well after the close of a fiscal quarter. This lag can be significant for fiscal quarter evaluations and even longer for year-end evaluations, during which reported valuations might become outdated.
The terms negotiated in the NAV facility will determine the scope of the assets subject to the lenders' valuation challenge. Generally, lenders may either challenge the valuation of the entire asset pool or select specific assets within it.
FREQUENCY OF VALUATION CHALLENGES
The ability of a lender to request and the frequency with which it may request a valuation challenge varies by facility. Some agreements allow lenders to request a third-party revaluation at any time. However, most facilities with valuation challenges set specific limits on how often the borrower's reported valuations can be challenged to maintain stability and predictability. Such limits could be temporal, like once per year unless an event of default occurs, or could be based on a good faith belief by the lenders that the actual valuation of an asset (or the pool of assets) is off by more than a specified percentage.
Lenders may also negotiate additional rights to address circumstances that provide a reasonable basis for further scrutiny—such as significant market fluctuations or changes in the operational performance of an asset or asset classes. This approach permits asset valuations to be more responsive to market conditions and/or specific asset performance while preventing excessive or arbitrary revaluations, which can be disruptive or costly for a fund.
SELECTION OF APPRAISERS
Borrowers and lenders typically negotiate a preapproved list of third-party appraisers, although borrowers may sometimes engage a second appraiser to contest the initial appraisal. When multiple appraisals are involved, the market is divided on how to determine the final valuation. We have seen both the median value of the three appraisals used (the borrower's original valuation and the two third-party appraisals), and some agreements use the median of just the two third-party appraisals. Additionally, we have seen situations where if multiple third-party valuations within a period vary significantly from the borrower's valuations, additional consequences may result, such as the agent being able to substitute its reasonable valuations on a go-forward basis, requiring a permanent haircut to the advance rate for the borrower's valuations, or requiring mandatory prepayment of the facility.
HANDLING VALUATION RANGES
For some asset classes, third-party appraisers may provide a range of possible values for an asset. In such events, the NAV facility documentation can address which value within this range will apply. Typically, the median value is used; however, the parties may agree to use either the higher or lower end of the range based on specific terms negotiated in the facility agreement.
COMPENSATION FOR APPRAISALS
Generally, the borrower will be required to pay for the third-party valuation if an event of default is in effect or the appraised valuation is a material deviation from the borrower's reported valuation; otherwise, the cost of the appraiser is borne by the lenders. We have also seen payment responsibility shift based on the percentage difference between the two valuations. For example, if the discrepancy exceeds a predetermined threshold, the borrower pays; if it is below, the lender pays.
IMPACT OF DISPARITIES WITH APPRAISED VALUE
Borrowers can negotiate a threshold requirement for how much the borrower's appraised valuation must deviate from the third-party appraisal for such appraised value to apply. For instance, if the difference between the borrower's valuation and the lender's third-party appraiser's valuation is less than a certain threshold, the NAV facility documentation may stipulate that there is no change to the valuation or that the median value of the borrower and third-party valuations should apply.
DURATION OF VALUATION APPRAISALS
In the absence of a valuation challenge, the appraised value remains valid until the next quarterly financial report is received. When a lender successfully challenges a valuation, the third-party appraised value will typically apply for a specified minimum duration, which may be longer than the next quarterly period. This minimum period is designed to avoid dissuading lenders from utilizing their appraisal right because of a short-lived impact on the borrowing base. It also ensures that the borrower cannot quickly revert to its valuation in an expedited manner depending on the timing of the third-party valuation in relation to the next regular quarterly or annual financial reporting date.
KEY TAKEAWAYS
Valuation challenge rights can be a helpful tool for lenders in NAV facilities to ensure reliable borrowing base calculations. Having the ability to challenge asset valuations can provide lenders with more comfort in underwriting certain types of NAV facilities. Additionally, proper valuations can be helpful to both borrowers and lenders as incorrect asset valuations may impact the availability or operation of such facilities due to their effect on pricing and advance rates. Effective structuring of these rights strikes a balance between the need for reliable and timely valuations and the associated costs and administrative burdens. Lenders, borrowers, and their counsel should carefully review NAV facility documentation to ensure clear terms for the selection of appraisers, breadth-of-valuation triggers, applicability of valuation ranges, allocation of third-party appraisal costs, and the duration of third-party appraisals.
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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.