Executive Summary
Over the last several years, a need has arisen in the fund finance market, which caters to private equity, venture capital, family offices, and other investment funds ("Funds") and their sponsors, for financing to support and leverage investment portfolios of highly concentrated asset pools or even single assets, in each case, with limited liquidity. These portfolios present challenges for financings, including issues with valuation, enforcement, and liquidation. To overcome these challenges, the market has looked to a combination of tools from the traditional net asset value ("NAV") and the margin loan markets. This Legal Update addresses the advantages of deploying these tools in a concentrated or single-asset financing market.
Background
Typical NAV Facility Structure
In a typical NAV facility, a lender or group of lenders provides a credit facility secured by the underlying portfolio investments of the Fund and related cash flows. The investment portfolio usually consists of various equity interests in non-public companies. NAV facility borrowers can vary and may be the Fund itself, a Fund subsidiary, or a special purpose vehicle. The collateral security structure may include a pledge of the equity interests of the borrower and/or the borrower's investments, as well as one or more deposit or securities accounts pledged in favor of and controlled by the lender, into which distributions from portfolio investments are routed.
Cash proceeds of investments deposited to the controlled accounts are available to prepay the NAV facility per the requirements of the specific facility, which may include a requirement to pay down the loan to maintain the required loan-to-value ratio and/or a cash sweep of some portion of the portfolio proceeds. So long as no default has occurred, controlled funds remaining after periodic facility prepayments are available for distribution to the Fund and its investors. Additional credit support may include guaranties from affiliated entities.
The amount of credit advanced typically is determined as a percentage of the fair market value of Fund assets that are approved as eligible collateral. Eligibility depends on factors such as the creditworthiness of the underlying obligor, the liquidity of the assets, and the investment strategies/relevant market sector of the assets. Additionally, limits may attach to such eligible assets to introduce haircuts on the portfolio value where limits are exceeded (such as an excess concentration in a specific market sector). Limits are reflected in the NAV facility and measured periodically (typically quarterly, depending on whether a liquid secondary market for the owned securities exists).
While setting the parameters of the eligible portfolio pool can involve negotiations, often the real challenge is the baseline value of the assets in the eligible collateral pool because these assets usually do not have an objective fair market value. Instead, the Fund sponsor typically performs the valuation based on an agreed-upon policy. Because this valuation takes place at monthly or quarterly intervals, there is an inherent lag in the valuation component of NAV facilities. To address this lag, lenders often negotiate the right to dispute the Fund sponsor's valuation and substitute an independent valuation by a third party.
In some NAV facilities, if valuation is disputed, borrowings may be limited and mandatory prepayments/cash sweep requirements may be paused. If, based on the revised valuations, a prepayment would be due, NAV facilities often include mechanics to permit the borrowing base to return to compliance over a specified period, as opposed to immediate prepayment, where the underlying assets are not liquid enough to allow an immediate sale and prepayment.
Margin Loan Structure
In a margin loan structure, a lender extends credit to a borrower against the value of investment securities owned by the Fund. The investment securities are typically traded on a public stock exchange. As with NAV facilities, margin loans have a borrowing base against which the loans are made and may have eligibility criteria (including the relevant exchanges on which the investment securities trade), as well as other eligibility criteria, such as concentration limits related to the market categories of the investments (e.g., energy, technology, hospitality). The lender often requires an account be designated to receive proceeds of the investment securities, with the account pledged to the lender and available to make required prepayments.
The publicly traded nature of the collateral in margin loans allows the borrowing base to be calculated daily by the lender on a mark-to-market basis. Accordingly, the lender does not need to negotiate valuation dispute rights because the valuations are publicly available and objective.
If a deficiency arises, the lender can require immediate action to redress the issue. In this scenario, the borrower will typically receive a "margin call" and be required to immediately prepay the loan or provide additional collateral or sponsor support to bring the margin facility into compliance. If the borrower fails to bring the facility into compliance, the lender is generally authorized to take immediate action and sell the investment securities (or provide instructions to the relevant prime-broker to make such sale) to repay some or all of the loan.1
The transaction structure of margin loan lending varies in two material ways from the standard approach in NAV facilities. First, the collateral has an immediate and reliable valuation. Second, because the collateral is liquid and has a reliable real-time valuation, the lender can readily enforce on the margin loan collateral. As noted above, in NAV facilities, lenders are not positioned to take immediate action on the collateral and may permit the borrower to devise a plan to redress any shortfall over a specified period, or the lender may simply stop extending additional credit and await dividends or other proceeds from the underlying collateral assets to be paid into the pledged account and swept to the lender.2
What to Know About Coupling NAV and Margin Approaches
To address the complications of financings secured by a single or concentrated asset portfolio, market participants have sought to deploy tools that combine elements of traditional NAV lending and margin loan lending. While the complications presented by these portfolios cannot be resolved by a single approach, combining tools from both markets can help advisors structure bespoke solutions. Specific options include:
- Price Proxy for Hard-to-Value Collateral. The traditional margin loan market benefits from having an immediate and reliable valuation of the underlying assets securing the financing, while in the typical NAV facility, the value of the collateral can lag the advancing of the loans. One solution is to seek price proxies for the underlying collateral. If the equity interests of a privately held company do not have a valuation that can be readily marked-to-market, there may be an alternative proxy, such as the trading price of the debt instruments of such private company. These proxies, if available, can act as a stand-in for the price of the applicable equity interests or could be used to simplify the negotiations of a lender's valuation dispute rights by stipulating that the dispute rights are only exercisable if there is a material movement in the price of the proxy asset. The price proxy approach borrows a tool from the margin lending market – namely, a real-time valuation – to make the valuation structure more reliable, which could impact advance rates, simplify negotiations around dispute rights, and facilitate more efficient remedial actions.
- Additional Collateral/Margin Calls. As noted above, in traditional margin lending, if there is a margin call, a borrower is generally permitted to provide additional collateral to support or repay the loan. In single or concentrated asset NAV facilities, the borrower may have limited liquidity with respect to the primary collateral. Accordingly, liquidating the asset pool may not be feasible or may require a steep discount to raise liquidity. Single or concentrated asset NAV facilities might apply the margin tool of supplemental collateral to redress any borrowing base deficiency. The collateral could be negotiated in advance or subject to lender's discretion. Incorporating this approach into single or concentrated asset NAV facilities may be more attractive to market participants because it may permit a more timely redress of any borrowing base deficiencies and may afford the borrower an opportunity to avoid steeply discounting assets during a market downturn to bring the facility into compliance.
- Alternative Credit Support Options. To achieve the same benefits as the additional alternative collateral approach noted above, participants in the single asset or highly concentrated asset market might consider using separate credit support strategies, such as equity support letters, guaranties, letters of credit, and/or comfort letters. The recourse under these strategies can vary and the provider's creditworthiness would be a key consideration, but these approaches may alleviate the complications arising from a single or concentrated asset-secured transaction, particularly where the collateral is difficult to value. These strategies may be more prevalent in traditional NAV facilities than margin loan structures but can benefit margin loans where the underlying securities are not publicly traded.
- Anticipatory Consents. Because the sale of non-public equity interests may trigger shareholder agreement provisions relating to change of control, drag along, tag along, rights of first refusal, and similar transfer restrictions, or regulatory consents, it may be advisable to obtain blanket consents in favor of the lenders exercising rights in collateral as a condition to the loan. As with the credit support options, this strategy may be used in NAV facilities more often than marginj lending structures, but it could be constructively deployed in both types of facilities where the assets are highly concentrated and have limited liquidity profiles.
Takeaways
There is a wealth of experience in the fund finance market from which to draw and creatively address issues posed by an evolving market seeking liquidity. Traditional NAV and margin loan features can be combined in the case of single and concentrated asset portfolios to efficiently resolve potential complications arising from these facilities and permit borrowers to monetize valuable assets while providing lenders with timely and adequate downside protections.
Acknowledgements
With special thanks to Mary Jo Miller for her contributions to this update.
Footnotes
1. In some margin facilities, the investment securities
are not fully liquid because they may be held subject to certain
restrictions (such as shares issued to insiders in a company in
connection with a public offering), but those special circumstances
are not the focus on this update.
2. Note that publicly traded securities will often be held by a Fund in a prime-brokerage account and if the relevant lender is not the same as the prime broker, the lender will be unable to have a pledge of the prime brokerage account itself but rather make arrangements to instruct the prime broker on dispositions of the asset in certain instances. Note that a lender should consider any lien and or margin loan arrangements between the prime broker and the Fund in such instance.
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