20th March 2024
Originally featured in Private Equity News
Today’s GPs are managing $10tr. That’s a five-fold increase in 15 years. To facilitate this growth, the industry has had to evolve new tools.
These are necessary. Everyone would have been worse prepared to navigate the challenges of recent years – covid, war, inflation, and spiking rates – without a broader set of financing options. However, using them should always be about delivering value for a fund’s investors and their own shareholders. This alignment of interest allows managers to build successful and sustainable franchises.
One addition to the private equity toolbox is NAV financing – a lending strategy executed against the net asset value of a buyout fund. Swift adoption, and a tighter liquidity environment since 2022, has led to some misconceptions about the purpose and benefits of this lending. These are worth addressing.
Distributions grip
One gripe is that managers use NAV finance to enhance distributions to investors at the expense of a portfolio’s performance and leverage. A review of 100 transactions totalling more than $13bn we’ve been involved in does not show that. Over 80% of the capital provided was used to finance growth and maximise value. Distributions was not the driving of the use case.
In today’s market with less liquidity and fewer exits available to buyout funds, hold periods have reached a near all-time high of around six years. As a result, around 60% of recent PE activity has been to support bolt-on acquisitions – a common use of NAV finance, which if well executed is a value accretive exercise to investors.
PE firms themselves are also impacted by lower liquidity but many want to continue to grow, diversify, promote, and to make bigger capital commitments to their funds. Again, this is a standard use-case and a signal of alignment for investors.
The squeeze on investor liquidity over recent years reflects a difficult exit environment, which has impacted net cashflows. In the prior decade, investors could expect more from distributions than would be called. Today, that is down to around 50-60% of those historic levels, which demonstrates that NAV finance has not become the panacea of investor liquidity. It was never intended to be.
Not window dressing
LPs are more rigorous in their due diligence than to be fooled by mere window dressing for tricky fundraising, especially in today’s liquidity constrained environment. The bar for GPs to secure capital is higher.
Managers will consult with their fund investors or advisory committee on the use of NAV finance, and they will disclose this in reporting. This is good practice and transparent. It also allows investors to better understand the use cases and intended benefits of these loans.
For managers, it helps them to demonstrate their ability to deliver more value by accessing a wider range of financial options, and specifically the tools that are most appropriate for any given situation.
Growth no distress
There is a perception that portfolios must be experiencing distress because of the macro backdrop, so managers turn to NAV finance to prop up underperformance.
Reality suggests the opposite. These facilities are most often used in strongly performing funds to unlock more growth. Being able to access alternative capital when other financing options have contracted is an important growth level for portfolio companies and PE firms.
That makes rational sense because higher performing portfolios and managers should have access to more attractive financing alternatives than underperforming ones.
More than a hammer
We saw similar misconceptions around ‘pass the parcel’ deals, subscription finance and continuation vehicles. These tools are all now better understood and regularly used. Judgement should be based on outcomes; and, in the case of NAV finance, this is a credit strategy that should be used to create value, improve performance, and to maintain alignment of interests.
Ultimately, if all you have is a hammer, everything looks like a nail. Thankfully, for today’s PE industry and its investors, the toolkit is better stocked.