Growth in Net Asset Value (NAV) credit facilities has increased exponentially in importance among private equity and other alternative investment funds since the pandemic relative to the secondary trading of assets as a means of creating liquidity, according to the Citco group of companies (Citco).
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“During the 2008 financial crisis, NAV facilities were primarily used for fund-of-funds, which are investment vehicles that pool capital and invest in underlying strategies managed by third-parties. Unlike leveraged loans, high-yield bonds or residential mortgages, NAV facilities enjoyed favorable credit outcomes during the crisis, with minimal defaults and losses. ”
The NAV credit facility, a little-known institutional financial product, experienced approximate 30% annual growth across Citco’s client base between 2019 and 2022, while secondary trading grew at an approximate 7% annual rate over the same period. At times, institutional investors have used NAV loans in lieu of a sale of assets on the secondary market as the latter could result in a loss. However, the NAV Facility is now growing in importance as it has the benefit of generating interim liquidity, allowing the assets to be realized in an orderly manner over time. In turn, asset sales have become challenging as central banks worldwide tighten financial conditions: the exit – or sale of assets – to investment ratio for private equity firms hit a 10-year low in 2022 (Pitchbook, 2022).
A NAV facility is most often a loan – extended by banks, insurance companies and specialty private lenders – to an alternative investment fund that is secured by the fund’s investments, which collectively comprise its NAV. These investments may consist of private equity, venture capital, infrastructure, credit, real estate or holdings in other investment funds.
The current size of NAV facilities globally is estimated to be less than $100Bn (The Fund Finance Association, 2022), which represents under 1% of the estimated value of private capital investments. Based on current growth rates, Citco estimates the NAV market could grow to over $600Bn by 2030.
Michael Peterson, Managing Director of Citco Capital Solutions Inc., said: “During the 2008 financial crisis, NAV facilities were primarily used for fund-of-funds, which are investment vehicles that pool capital and invest in underlying strategies managed by third-parties. Unlike leveraged loans, high-yield bonds or residential mortgages, NAV facilities enjoyed favorable credit outcomes during the crisis, with minimal defaults and losses.
“For alternative asset managers, a prudently structured NAV facility provides liquidity, helping a manager to fulfill its fiduciary duty to its investor clients. For lenders, they provide a secure, low loan-to-value credit structure with a diversified collateral pool and favorable alignment of interests. Systemically, these facilities serve as a safety valve for alternative investment vehicles, facilitating the efficient allocation of capital that underpins the global economy.
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“When we look at the performance of our clients during the financial crises, they experienced favorable outcomes. Moreover, we believe NAV loans provide a good risk adjusted investment for the lender. While NAV lending is an evolving segment of alternative asset lending with expanding demand, we believe it serves an important need and there are key structural protections for lenders, borrowers and the broader system.”
Typically, funds borrow to generate liquidity and deploy additional capital after the commitments from their investors are exhausted. This may be due to an unforeseen extreme event – such as the Covid pandemic – requiring them to support existing investments, or they may seek to take advantage of lucrative follow-on investment opportunities.
An alternative use of a NAV loan is when institutional investors seek incremental leverage on their Limited Partnership (LP) holdings in alternative funds. Typically, the investor submits a subset of their alternative investment holdings to a lender as collateral for a NAV loan, thus creating liquidity. Historically, institutional investors have tended to use this type of loan in order to generate liquidity when the cash flow from their LP portfolio is expected to slow.
NAV lenders tend to be conservative in their structuring and underwriting, and rely on several features of the facilities to protect themselves:
- First and foremost, they are low leverage – usually between 5% and 25% of the fund’s value. By looking at historical data, including investment performance during and after the great financial crisis, lenders size facilities with a requisite margin of safety to ensure the borrower can withstand a severe downturn. Across Citco’s client base, it has seen advance rates range from 3% to 20% of eligible collateral.
- Second, unlike a leveraged loan to a company sponsored by a private equity firm, a NAV facility’s collateral consists of a diversified pool of investments, typically a dozen or more individual positions. This diversification protects the lender against idiosyncratic shocks at the portfolio level.
- Third, the maturity of the facilities are typically matched with the expected liquidation timeframe of the underlying assets. Unlike products which engage in maturity transformation, there is no risk of a “run on the bank”.
- Lastly, these facilities benefit from a structural alignment of interests: both the fund sponsor – the asset manager – and its investors are fully subordinated to the NAV lender in priority of payment. For an asset manager to continue its main business of raising future capital, it would be disastrous to default on a NAV facility. Though private equity managers are notoriously clever game theorists when dealing with lenders, every manager understands that fundraising is a repeated game. Similarly, the fund borrower shares an alignment with the lender in that a default would create a number of structural and reputational issues for its investors.
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