Allocators Aren’t Happy With the NAV Lending Craze
These newly popular loans can add “leverage on leverage,” says Cambridge’s Andrea Auerbach.
As private equity firms increasingly tap NAV loans, investors are raising concerns about transparency and the amount of leverage in their funds.
Net asset value loans — revolving credit facilities backed by an entire private equity fund, rather than a single company in the portfolio — have become popular as PE firms face fundraising and distribution challenges.
Neil Randall, head of private equity at Teacher Retirement System of Texas, is a critic of the loans. “NAV loan utilization is an underwriting consideration for PE commitments,” he said. “We don’t like seeing them, particularly at current rates.”
Some allocators, including Randall, say NAV loans add a second layer of leverage to a private equity fund, changing how investors need to assess risks. Asset owners also are concerned about the lack of transparency they say managers provide when they use loans.
For managers facing tough market conditions, NAV loans allow them to pursue add-on acquisitions without calling capital from investors, and to offer cash distributions during a time of tight liquidity.
But the use of the loans changes an allocator’s calculus when considering the risks of their portfolio.
According to Andrea Auerbach, head of global private investments at Cambridge Associates, her team pays a lot of attention to a manager using leverage at both the portfolio company level and at the fund level. “That’s leverage on leverage,” she said. That can restrict the growth of portfolio companies in the fund, Auerbach explained.
Over the course of the life of most private equity funds, particularly during good times, that’s not an issue. But for those that run into bigger problems, such as a company failing in a tough economy, added leverage can compound the damage.
Gaurav Patankar, chief investment officer of Merced County Employees’ Retirement Association, worries that NAV loans give managers latitude to help what are ultimately “unviable companies” on their books — rather than letting them fail if they didn’t have access to this capital. That becomes problematic when the struggling companies’ debt is tied to the rest of the portfolio.
“Most LPs would want GPs to wall off great companies, focus on them, triage the salvageable ones, and de-emphasize the unviable,” he said.
Another allocator put it more bluntly. “I don’t want to collateralize one company with another,” the limited partner, who spoke to Institutional Investor on the condition of anonymity, said. “It feels like an unnecessary risk.”
What’s more if a fund goes belly-up — which is admittedly rare — investors are paid out after NAV lenders, which are higher up in the capital structure. “It can create a risk for the entire portfolio that has been triggered by one bad asset,” said Steven Richman, partner at law firm Seyfarth Shaw.
More concerning for some investors is they report being taken aback by their investment managers choosing to take out these loans. “Their manager may be incurring an NAV facility when it was not abundantly clear in the LPA [limited partner agreement],” Richman said.
According to Richman, and his colleague Shamim Mohandessi, the use of NAV loans is technically allowed by most LPAs. “The LPAs don’t say that the manager can go get a NAV facility,” Mohandessi said. But “the LPAs say they can leverage those portfolio assets.” Many investors took this to mean that managers could take out loans against portfolio companies or use subscription lines. They many did not expect NAV loans.
Richman said there is also concern about NAV loans improving IRRs, which are used to determine managers’ incentive fees, even though interest payments are deducted directly from the funds themselves.
That works for investors who use IRR as a measure of performance, Richman added. But he said that from a gross performance perspective — when returns are measured by a multiple of returned capital to investors, NAV loans generally dampen performance.
Some limited partners, however, want their managers to tap NAV loans.
“There are LPs out there where maybe the tap for distributions has slowed to a trickle,” Auerbach said. “If their GP is looking at using a NAV loan, some LPs may say ‘that’s great news.’”
Whether or not they benefit from NAV loans, allocators are looking to clear up some of the gray areas, especially as they make new fund commitments.
Ropes and Gray attorney Patricia Lynch said she has seen an increase in the number of limited partner agreements that explicitly allow the use of NAV facilities.
“There are some newer funds that are being formed where the GP has to go out to the LPs and get consent,” she said. “There are other funds where the fund has flexibility to put a NAV facility into place if it thinks that it’s the right thing to do at the time.”
According to Mohandessi and Richman, guardrails can include a limit on the total amount of leverage a general partner can use and provisions that prevent general partners from earning fees on the outstanding portion of a NAV facility, which can better align the interests of both private equity firms and their investors.
“One other thing that we’re asking for, whether it’s a new fund or a re-up, we’re asking for advanced notice if there’s any NAV borrowing,” Mohandessi said. “We view it as the bare minimum.”