NAV lending and the risk of ‘bad acts’: The 5 initial questions to ask

One potential risk all lenders face is that the borrower may engage in actions and activities which reduce the value of the collateral against which their loans are secured. This is a risk which is even more pronounced with respect to NAV loans given the structure of such facilities. Yet when addressing risks there are a range of factors which investors can consider to better assess the extent to which they are exposed to such ‘bad acts’ by borrowers.

What is NAV Lending?

Net Asset Lending is where private equity (‘PE’) firms borrow against the Net Asset Value (‘NAV’) of the assets in their funds. To better understand the dynamics involved it is useful to consider the typical life cycle of a PE fund. At the start (‘early life’) a PE firm will raise capital via a fund or other type of special purpose vehicle. This capital is then utilised as the equity component to buy a company where the company balance sheet may then be ‘levered up’. Importantly, where the company is ‘levered up’ the loans remain within the balance sheet of the company rather than that of the fund. Eventually (‘later life’ of the fund) the assets in the company, or the company itself, will be sold and capital returned to the fund which will then be utilised to repay investors.

Within this life cycle NAV lending allows the PE firm or sponsor to add another level of leverage by borrowing directly within the fund. It is worth noting that NAV lending is not to be confused with what may be termed ‘fund revolving facilities’. Under ‘fund revolving facilities’ the fund can borrow money with the lenders secured against the fund’s pledge to call additional capital. The aim of such loans is to reduce the frequency of fund capital calls thereby allowing the PE firm to smooth capital calls and hence the internal rate of return (‘IRR’) generated. Such facilities are typically used by ‘early life’ PE funds which are in the capital drawdown phase. By contrast NAV finance is typically used by ‘later life’ PE funds. With NAV loans the net value of the fund’s holdings, discounted for factors such as creditworthiness etc, provides the borrowing base against which the fund can borrow.

There are several reasons why a NAV loan may be attractive to a sponsor. Firstly, it may allow the fund to return capital to investors while retaining prize assets or increasing the holding period of assets to maximise returns. Secondly, it may assist a sponsor to achieve a higher level of aggregate leverage within a deal beyond that which the company’s balance sheet can sustain. Finally, it may assist the sponsor in the restructuring of a fund where it is reaching the end of its life and the general partners in the fund want to release capital to invest into a new vehicle.

The Risk of ‘Bad Acts’

When entering NAV loans, lenders assess the investments and other assets owned by a sponsor that are to be included in the collateral pool. After closing the lenders then continue to monitor those investments and assets for compliance with the financial covenants etc that have been negotiated and set out in the loan documents. One of the key aspects that NAV lenders need to focus on is the risk of ‘bad acts’ by the sponsor. ‘Bad acts’ are where a borrower may take actions that result in the underwritten investments and other assets ceasing to either (a) be owned by the borrower or (b) becoming subject to the claims of other creditors in contravention of the terms of the loan documents/covenants. Such risks are in addition to the “market risk” of the facility; i.e. the risk that the value of the borrower’s investments and assets will decline. Specific examples of ‘bad acts’ might include a borrower :

(a) transferring an investment or asset to an affiliate,

(b) selling an investment or asset at less than full value or for illiquid consideration,

(c) pledging an investment or asset to another creditor,

(d) directing proceeds of an investment or asset to an account other than the pledged account, or

(e) commencing an insolvency proceeding as a means of obstructing or delaying creditors’ exercise of remedies.

The issue facing most NAV lenders is that the ultimate investments/assets establishing the NAV of the fund are typically owned/controlled by the sponsor either directly or indirectly through one or more special purpose vehicles. Accordingly, though the risk of ‘bad acts’ exist for all loan types, it is more pronounced with NAV lending as the loan to the fund is ‘remote’ from the assets in the company which determine value of the equity backing the loan. Though lenders will negotiate detailed covenants limiting such actions, as lenders do not control these assets, they remain more reliant on the sponsor to comply with such negotiated limits. While breach of the NAV loan covenants may give rise to an event of default, such a breach may already have negatively impacted on the value of the collateral making it less likely that the loan will be repaid in full.

Mitigating the Risk of “Bad Acts”

To assist in assessing the risk of ‘bad acts’ the NAV lender should start by asking five basic questions. One of the key risk factors that lenders should consider in evaluating ‘bad act’ risks with respect to NAV loans is the market profile of the sponsor. The potential lender to a NAV facility may accordingly consider three initial questions when assessing the profile of the sponsor :

• What is the frequency of NAV financing? : Certain sponsors are serial users of NAV financing such that the use of these types of loans is an integral part of their business model. Such characteristics may be viewed favourably as sponsor (a) has a verifiable track record of responsible use of NAV loan financing and (b) continued need for financing to operate its business acts as an effective incentive to avoid ‘bad acts’ under the existing loans.
• What is the breadth of the sponsor’s “brand”? : Certain sponsors have brands that expand well beyond the fund involved in the particular financing. Such sponsors may have extensive asset management platforms encompassing a broad range of investment strategies/products. Such sponsor platforms are more likely to (a) possess resources dedicated to operational integrity and compliance and (b) view ‘bad acts’ as having a detrimental impact on their ‘brand’.
• What are the sponsor’s sources of equity capital? : Lenders may take comfort from a sponsor’s management of a significant amount of external money. External capital (and particularly institutional capital) can act as a check on certain types of opportunistic behaviour.

Beyond the market profile of the sponsor the NAV lender should also consider when assessing the risk of ‘bad acts’ :

• What is the relationship between the lender and the sponsor?

Another key factor that lenders consider in evaluating ‘bad act’ risks with respect to NAV loans is the overall relationship with any given sponsor. Where a sponsor has extensive touch points with a lender and its affiliates, comfort may be taken that a financing transaction is less prone to ‘bad acts’ given the extent of a lender’s familiarity with a sponsor and its principals.

• What are the characteristics of the investment portfolio?

Finally, lenders may also consider the impact arising from the characteristics of a sponsor’s investment portfolio on the risk of any ‘bad acts’. While the characteristics of a sponsor’s investment portfolio might not impact directly on the likelihood of ‘bad acts’ occurring it can ultimately determine the magnitude of the impact on the lender. As with market risk, a concentrated portfolio raises the exposure to lenders in the event of any impairment of the portfolio, including any ‘bad acts’. As a result, the consequences of a ‘bad act’ with respect to a single investment in a well-diversified portfolio is likely to have less impact on a lender than a ‘bad act’ relating to ‘trophy’ or sole asset in the portfolio.

The risk of ‘bad acts’ by a sponsor undermining the position of lenders is a material risk for all types of loans. The magnitude of this risk however varies depending on the form of lending with it being more material for NAV lending given the nature of the loan. Though the risk is higher for NAV lending, by addressing at least five basic questions the lender can increase their ability to assess and understand the risks around such loans. By doing this the lender will be in a better position to manage the risks inherent in such transactions and thereby maximise the returns available.