Fund finance has developed into an important source of liquidity for private equity funds.
Historically, fund finance has been limited to credit, secondary and infrastructure funds, but now we are seeing private equity tap into this market, which continues to see significant activity year over year. Fund managers have been seeking additional liquidity since the wake of the pandemic, and amid an uncertain market new lenders are rushing in to fill the void. As a consequence, demand is outpacing supply, creating fertile ground for innovation in deal structure.
Traditional fund finance typically consists of subscription line financing, in which a fund would pledge to a lender the right to call capital from limited partners. The lender’s recourse is limited to the partners’ obligation to make capital contributions in accordance with the terms of the fund documents, and the loans are short-term, requiring periodic paydowns. These revolving loan facilities allow the fund to make fewer capital calls, which smooths IRR and saves all parties involved from the administrative burden of multiple calls.
In contrast, net asset value, or NAV, finance is typically used for later-stage funds or funds that are acquiring existing portfolios. Under this structure, the fund pledges its portfolio holdings to the lender, the net value of which—after discounting based on the creditworthiness of the underlying portfolio and certain other factors—calculates the borrowing base against which the fund can borrow.
We have seen a real uptick in the use of NAV facilities, especially in the Canadian markets. NAV financing has allowed fund managers to leverage portfolio assets in a way that goes significantly beyond subscription financing. Using traditionally illiquid fund investments, fund managers can accelerate distributions to limited partners, finance add-on investments without calling capital and bridge new investments for additional funds.
NAV facilities are diligence-intensive, requiring not only a review of the fund and its partners, but also a deep dive into the portfolio. Step in rights and consents are dealt with by structuring the borrowing entity above the portfolio investments. Mandatory prepayments are triggered by changes in loan-to-value ratio and covenants govern asset eligibility. Meanwhile, as large-cap private equity has entered the market, we have seen sponsor-friendly and leveraged loan type provisions become more common in mid-cap deals.
In a turbulent market marked by persistent uncertainty, lenders and borrowers alike are looking to fund finance to facilitate portfolio growth and return to their investors. We expect to see continued growth in NAV facilities and hybrid facilities (which combine subscription facilities and NAV facilities into one agreement) in both the United States and Canadian markets in the second half of 2022 and into 2023, as the need to maximize liquidity remains a priority for fund managers.
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