The ‘small’ approach that’s big news in fund finance
Up to now, net asset value-based fund finance facilities have mainly focused on broad, diversified portfolios, but that may be changing
Comment by Matthew Kerfoot and Edward Newlands of Dechert and Khizer Ahmed of Hedgewood Capital Partners, Private Debt Investor, Oct 2020
Solutions emanating from the fund finance industry continue to play an important role in the eco-system of the private capital funds industry. Credit lines secured by portfolios comprised of a small number of assets (so-called ‘concentrated NAV facilities’) have recently garnered significant interest amongst GPs in the Private Equity space.
At a macro level, concentrated NAV facilities can be distinguished from traditional NAV facilities by reference to the nature of the collateral that secures such borrowing. Whereas most traditional NAV facilities are secured against diversified pools of assets (e.g. borrowing by a PE secondaries fund secured by multiple LP interests in a range of underlying funds and strategies), concentrated NAV facilities are generally secured by a small number of underlying assets – it is not uncommon to come across only two or three underlying assets comprising the bulk of collateral value supporting a given facility. In fact, we have recently worked on a transaction where a fund’s borrowing was secured by a single underlying portfolio company.
There might be any number of reasons why borrowing at the fund level in the form of a concentrated NAV facility might be preferable to that at the individual portfolio company level. A company might have an over-levered balance sheet to begin with, or it might be going through a difficult or transitional phase in its corporate life and, therefore, may not have unfettered direct access to debt financing. It may have breached its loan covenants and face an effective freeze in the corporate loan markets. Economic or financial market conditions may reduce the supply of new debt finance or make it more expensive to refinance existing debt. Finally, diversification amongst lenders in the fund eco-system and a reduction in exposure to correlated action by a small subset of lenders in the event of a system wide stress event is a sensible objective in its own right.
Why now?
The concept of NAV based finance facilities as a bona-fide portfolio management tool is well known to, and understood by, most GPs. In contrast, concentrated NAV facilities are somewhat of a niche product and have only recently entered broad based discourse. There are a few contributory factors. The on-going Covid-19 crisis has dramatically changed the financial and operational landscape for privately owned companies. Fall in revenues for companies across multiple sectors of the economy, and opacity with respect to the timing and extent of any recovery, has been accompanied by a pull-back in debt financing from traditional sources. Like others, PE owned companies have taken steps to shore up liquidity where possible. LPs have been asked to contribute additional capital to funds that are still within their investment periods and portfolio companies have drawn down on existing bank credit lines where available. Challenges still remain, most notably in the form of a fall in distributions, the relatively sluggish pace of activity in the secondaries market, relatively subdued valuations for companies contemplating primary stock market listings, and, where they still exist, a revision downwards of bids from potential buyers of individual portfolio assets. Furthermore, notwithstanding notable exceptions, the majority of GPs raising new funds have found asset raising to be sluggish. All the while, market dislocations and a general pull-back in valuations continue to uncover potentially attractive new buying opportunities.
It is little wonder then that GPs have shown a greater interest in hitherto under-explored portfolio financing based liquidity solutions, both in order to deal with immediate and emerging portfolio needs as well as with a view to positioning their portfolios more robustly to take advantage of emerging opportunities. Concentrated NAV facilities fit the bill as one such solution.
Uses and benefits
Concentrated NAV facilities can be used to meet a range of objectives either at the level of the fund or at that of an individual portfolio company. When directed towards individual portfolio companies, these facilities have been used to:
- capitalize on bolt-on growth opportunities
- provide portfolio companies with financial cushion before sale and/or for purposes of pre-exit balance sheet clean up
- cure debt covenant breaches
- refinance expensive preferred equity or debt financing
- buy out co-investors in single asset investments
- finance early (partial) distribution to existing fund LPs without asset or portfolio sales
- provide warehouse financing for acquisitions and future syndication
- access bridge financing between fund closures in instances where fund raising has progressed slower than expected
- undertake contingency planning with respect to capital availability during periods of market stress
As a tool targeted at portfolio companies, a key benefit of fund level concentrated NAV facilities is their functionality in addressing an equity need at the cost of debt. Furthermore, given the non-dilutive nature of debt versus equity, the overall economics are likely to look attractive from an equity investor’s perspective. Such facilities can be structured quite flexibly in order to suit a borrower’s requirements – the borrower can be a fund, a special purpose vehicle or an individual portfolio company and collateral arrangements can be tailored to suit the structural features of a given transaction. Another benefit is that in contrast to traditional corporate debt, most concentrated NAV facilities contain very few covenants at the individual company level, relying as they do on fund/portfolio level credit risk mitigation mechanisms, thereby imposing a comparatively lighter burden of compliance. Also, experience shows that such facilities are quicker to execute as compared to bilateral credit facilities secured at a single company level.
Some considerations
A borrower should carefully consider a number of factors, and meet certain pre-requisites, before engaging lenders in conversations about concentrated NAV facilities. On the assumption that a GP does not have recourse to existing liquidity mechanisms (e.g. LP committed capital or a pre-existing fund level credit facility) that might be cheaper and/or quicker to access, a careful review of a fund’s LPA to identify any restrictions on the introduction of fixed-term debt at the fund level is a logical starting point. Engagement of the fund’s LPs with a view to seeking their agreement to any financing transaction is likely to follow soon thereafter. Identification of assets to be pledged as collateral, and analysis of structural issues around these are other early stage considerations. Finally, careful thought needs to be given to headline terms that are likely to form the core of any financing transaction – the use of proceeds, what the draw down schedule is likely to be given portfolio requirements including the potential need for a delayed draw feature, a suitable LTV attachment point, the level at which borrowing is likely to take place (e.g. fund, wholly owned subsidiary/SPV, individual portfolio company), the availability or potential use of guarantees as a supplementary credit support mechanism, cash versus PIK coupon, maturity, proposed repayment waterfall and mechanisms for addressing any potential early termination events and/or events of default being some of the more obvious ones in this respect.
Banks or specialty lenders?
It is a noteworthy phenomenon that whereas large, well known banks dominate the provision of diversified NAV credit facilities, the main players in the concentrated NAV facility business appear to be specialty finance companies that operate through dedicated fund vehicles funded by a combination of institutional and non-institutional investors. The relatively high balance sheet capital charges associated with such facilities appear to be one reason why most mainstream banks shy away from this specific segment of the fund finance market, though a few notable exceptions do exist. Another reason is the requirement by banks for their NAV based credit exposure to be secured by well diversified pools of assets. By definition, concentrated NAV facilities do not meet this requirement. The size of transactions can also be a hurdle. It is very common to come across transactions in the $10m-$25m range in the concentrated NAV facility business. For most large banks, this size is too small given the amount of work involved and other considerations highlighted above.
Concentrated NAV facilities can be expensive, particularly when compared to traditional NAV financing backed by large, well-diversified portfolios of assets. It is not atypical for the all-inclusive cost to be in high single or low double digits, particularly when borrowing from a non-bank lender. As with debt transactions more generally, pricing for a given transaction is a function of a number of factors including the LTV, maturity, diversification (or lack thereof) in the collateral pool, use of proceeds and existence of (or otherwise) of additional risk mitigation mechanisms. Pricing differences between different lenders are only one dimension that borrowers should consider as they evaluate multiple offers. Qualitative factors such as flexibility of use, covenants and cure mechanisms should an event of default materialize are arguably as important in forming a view about the overall attractiveness of a given offer.
Where next?
The on-going Covid-19 crisis has given significant publicity to the concentrated NAV product and familiarity is only likely to grow in the foreseeable future. The relatively high cost of such facilities notwithstanding, once deployed, concentrated NAV facilities can prove to be multi-use and can provide GPs with a flexible tool to address a wide range of portfolio objectives. This can prove very attractive in an environment where traditional lenders are likely to continue to tread carefully with respect to increasing their credit portfolio exposures. The highly bespoke nature of such facilities that are designed to achieve close alignment with borrower requirements, and the relative speed of deployment are other compelling features. Finally, a possible reduction in reliance on banks as sole or main providers of fund level debt financing is also a notable ancillary benefit. It would appear reasonable to expect that the use of concentrated NAV facilities is set to grow in the foreseeable future.