Net asset value (NAV) loans have become an increasingly popular financing tool for private equity funds whereby a mature private equity fund borrows at the fund level (or higher) based on the net equity value of an existing, diversified portfolio.
Understandably, most commentary has focused on NAV loans as financial tools at the fund level because NAV loans are secured by the overall value of the portfolio and the additional leverage does not touch the portfolio company balance sheet. However, NAV loans can certainly impact a portfolio company's operations and it's important to consider the potential impact of NAV loans on the incentives of a portfolio company's board and officers. While these loans can offer strategic advantages, they may also create conflicts of interest or misaligned incentives between the private equity firm and the portfolio company's management team.
NAV loans can certainly impact a portfolio company's operations and it's important to consider the potential impact of NAV loans on the incentives of a portfolio company's board and officers.
The significance of NAV loans in the current market landscape lies in their ability to address liquidity needs and provide flexibility in portfolio management. As the private equity industry faces headwinds in a high interest rate environment, and fund cycles increasingly extend, funds are seeking ways to hold onto investments for longer periods, allowing portfolio companies more time to achieve their full potential. In the face of limited partner pressures to return capital, NAV loans offer a solution to this challenge by providing an alternative source of capital.
Notwithstanding this flexibility that NAV loans provide to operators, the additional leverage adds another competing incentive for private equity sponsors, which could foreseeably create risks to their portfolio company.
Benefits of NAV Loans for Portfolio Companies
One of the primary benefits of NAV loans is that they allow private equity firms to extend their investment horizon beyond the typical fund life cycle, which eliminates or extends one of the most common friction points between a private equity fund and its portfolio company management team. This flexibility can be particularly advantageous given the current interest rate environment which has limited both financing and exit opportunities and created situations where portfolio companies are requiring additional time to realize their full potential.
For instance, in today's high interest rate environment, companies are trading at depressed multiples relative to their 2021 peaks. Therefore, a portfolio company might be more interested in making strategic acquisitions or pursuing add-on investments today while waiting for a lower interest environment to time their exit. Of course this can cause friction with a private equity fund's investment timeline, which might dictate that the sponsor return funds to the limited partners in a 3-5 year period. Through the use of a NAV loan, the fund can both make distributions to its limited partners without forcing a premature exit or it can provide capital to fund such acquisitions even if the fund has otherwise exhausted its capital commitments. This extended timeline enables portfolio companies to wait for more favorable market conditions or interest rate environments before pursuing an exit strategy.
Another key advantage of NAV loans is that they do not directly burden the portfolio company with additional debt on its balance sheet. The loan is secured by the private equity firm's stake in the portfolio company, rather than the company's assets. This can be beneficial for portfolio companies that may already have significant debt obligations, especially if such debt was incurred before the recent spike in interest rates or if those companies prefer to maintain a cleaner balance sheet for strategic reasons.
Potential Risks and Challenges to Operations
While NAV loans might help solve for some friction around the timing of a portfolio company exit, they also might exacerbate those issues down the road or in some cases, create friction due to the performance of an unrelated portfolio company. NAV loans specifically contain a covenant that the fund's eligible investments maintain a minimum net asset value. Furthermore, NAV loans are often secured by controlling equity interests in the portfolio companies through which the fund holds such eligible investments. Therefore, a default on a NAV loan tied to the performance of one portfolio company could trigger the liquidation of another portfolio company.
Importantly, operators who are often either rollover sellers or a hired management team, will most likely be incentivized with rollover or incentive equity from the portfolio company and most funds are structured such that each portfolio company has its own credit facility secured by the assets of the portfolio company. Therefore, operators should be aware that their fates could very well become intertwined with unrelated portfolio companies which in most cases they may not even be aware of, and they almost certainly will not get a chance to diligence.
Potential Conflicts of Interest and Systemic Risk
While there are many justifications for NAV loans and there is a tremendous opportunity to create win-win situations for both investors and management, it should be noted that there are some fact patterns that create clear conflicts of interest.
For example, a NAV loan could be used to make distributions to limited partners to lock in a preferred return hurdle and then make carried interest distributions. In that event, the general partner is clearly de-risking from the future performance of the fund and putting additional risk on any stakeholders at the portfolio company level. In other examples, where loan proceeds are used to bolster a specific portfolio company's balance sheet or acquisition strategy, risk is being shifted from the stakeholders in one portfolio company to another.
Finally, like any form of leverage, NAV loans expose private equity firms and their portfolio companies to interest rate and market volatility risks. Rising interest rates can increase the cost of servicing these loans, potentially eroding returns and straining cash flows. It should be noted that most of the benefits of NAV loans lie in the assumption that interest rates will fall and multiples will eventually return to 2021 levels, which is of course not guaranteed. In many cases, NAV loans themselves may be shifting that risk to a different set of stakeholders.
NAV loans have emerged as a popular financing tool for private equity funds, offering both benefits and potential risks for the operators of portfolio companies. While they provide liquidity and extend investment horizons, allowing portfolio companies more time to grow and achieve their full potential, they also introduce new risks related to cross-collateralization and conflicts of interest.
For portfolio companies and their managers, it is crucial to carefully evaluate the potential impact of NAV loans on their operations and strategic objectives. While NAV loans can be a valuable tool for private equity funds and their portfolio companies, they should be approached with caution and a thorough understanding of the associated risks and implications. Effective risk management, robust governance frameworks, and open communication between all stakeholders are paramount to mitigating potential pitfalls and ensuring that NAV loans contribute to the overall success of the investment strategy.
Originally published by Middle Market Growth, 29 July 2024
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