NAV finance has come a long way in just the last few years. 17Capital executives Robert de Corainville and Greg Hardiman explain the dynamics of the market in 2022 and how they suggest explosive growth in the years to come.
The past year marked another all-time high in NAV financing activity across the private equity industry, further building on the acceleration in market development that began during the pandemic. Two numbers – 50 and 40 – capture the story in a nutshell. The first refers to the 50 percent growth in deal volume the market experienced in the 12-month period ending in September 2022. The second refers to the 40 percent increase in the size of the average transaction during the same period, reflecting adoption of NAV financing by the largest institutional managers and larger underlying portfolios.
While dislocation in the financial markets and reduced liquidity conditions certainly played a role in driving growth in 2022, the key takeaway applies throughout the market cycle: NAV financing is expanding because private equity managers and investors are recognizing it as a valuable, flexible tool to enhance growth across multiple levels of their businesses.
PE managers are using NAV financing to create value in their funds through add-on acquisitions at existing portfolio companies, often as an alternative to mezzanine financing or additional equity investment. At the management company level, NAV finance is increasingly used to support larger general partner commitments, strengthening alignment with their limited partners. We have also seen managers utilize NAV financing to drive platform expansion into new geographies and asset classes, all while retaining equity ownership.
NAV financing also enhances liquidity in a number of ways. It can be used by PE firms to facilitate succession planning and increase ownership for the next generation of firm leaders. It can also be used to generate distributions for fund investors, often as an alternative to individual portfolio company recapitalizations or selling prized assets in suboptimal market conditions.
Strength amid turbulent markets
That last use proved critical in 2022 when markets buckled and the traditional avenues for driving liquidity and raising additional dry powder all evaporated at the same time. The falloff, in many cases, was dramatic. For instance, global IPO activity dipped 45 percent by volume and 61 percent by number of deals in 2022, EY Global reported in mid-December.
NAV financing has given PE firms the ability to hold strong assets longer and create additional investment capacity to opportunistically pursue growth opportunities through new acquisitions or boost investments in existing holdings.
PE investors have also benefited from NAV financing as a means to support further investment with their highest conviction managers and rebalance portfolios amid a period of reduced realizations and strained allocation budgets. Institutions are demonstrating their long-term commitment to the asset class, rather than offloading core exposure into the secondary market at substantial discounts.
NAV financing demonstrated its value as a flexible portfolio management tool during the early stages of the pandemic, and it is playing the same role today during a more prolonged period of challenged macroeconomic conditions.
- Increased use of NAV by the top tier firms: At 17Capital, roughly 90 percent of the capital we have deployed recently has been alongside top 100 global managers (in terms of capital raised). We have seen a notable pickup in interest among the largest US managers, many of whom are now planning to utilize NAV financing for the first time. Once a private equity organization uses NAV financing once, they tend to identify multiple applications for the solutions across their platforms. As such, 50 percent of the NAV finance investments we’ve completed to-date have been repeat transactions with the same counterparties.
- NAV loans taking a bigger share of the overall market: NAV financing takes two forms: senior loans and non-recourse facilities, often structured as preferred equity. Preferred equity, which offers greater flexibility at a higher cost of capital, had been the primary form of financing since this market emerged during the Great Financial Crisis. More recently, however, NAV-based loans have been gaining popularity because of their broad applicability as a portfolio optimization tool at the PE fund level. We expect this trend will continue, following a similar adoption curve as traditional subscription lines of credit.
- Growing comfort with NAV financing among limited partners: PE fund investors are increasingly familiar with NAV financing and appreciative of its flexibility and value creation potential, both from the standpoint of using NAV financing in their own portfolios and its use by the strongly-performing PE firms they invest with. Nevertheless, it is important that managers clearly explain their rationale for using NAV financing and demonstrate how it will add value for fund LPs.
In a related development, LPs are gaining exposure to NAV financing directly by investing in NAV financing funds, recognizing that such investments can help diversify their private credit allocation and provide strong risk-adjusted returns. We are confident that NAV finance will quickly become an established asset class within the private debt universe, a view that is increasingly supported by leading investment consultants.
Where we go from here
NAV financing is not new. The market has been around for roughly 15 years. But growth has accelerated since 2020 for reasons we have cited here, and we fully expect the pace of growth to continue in the years ahead. Much like direct lending and GP-led secondaries, NAV financing has made the transition to a permanent, institutional tool within the private equity landscape.
One reason for our optimism is the sheer scale of the PE ecosystem. Data from Preqin put global AUM of private equity funds at $8.3 trillion at the end of 2021, with unrealized NAV of $1.6 trillion in North American and European PE firms. Based on those numbers, we think the NAV financing market, currently about $100 billion, could triple in size by 2025 and reach $700 billion by 2030. The robust market activity in 2022 has only bolstered our confidence in those projections.
To sum up, NAV financing is an essential tool for driving value creation in private equity and the industry has recognized its potential.
