The rise of NAV lending

Private equity is suffering from a dearth of distributions. The M&A and IPO markets are both ostensibly shut, yet investors urgently require capital back as they find themselves significantly overallocated to the asset class.

Unable to make fresh commitments until previous vintages have paid up, swathes of the fundraising market are on hold. Indeed, much of the private equity industry faces paralysis until that elusive liquidity can be found.

This, of course, is the remit of the secondaries industry. Secondaries have largely been used as a portfolio management tool for non-core assets over the past decade. But from late 2021, large North American investors started selling part of their LP book to create capacity to invest in new vintages as capital calls started to outweigh distributions.

“The trend has only accelerated as rates have risen and public markets have sold off, creating large overexposures to alternatives, known as the denominator effect,” says Fokke Lucas, partner at 17Capital. “The majority of these situations, perhaps 80 or 90 percent, will be solved through the traditional secondaries sales, where LPs are accepting discounts in the 10 to 25 percent range. But we are also seeing situations where LPs need to manage exposure but don’t want to take that hit and don’t want to give up the relationships they have invested in with sponsors.”

This is where net asset value financing comes in.

Liquidity seekers

Appetite for structured solutions including NAV financing really began to emerge in Q3 and Q4 of last year, when a number of large books of LP interests were taken to market but failed to reach the sellers’ reservation price. In many cases, there were underlying issues in the portfolio, and the discounts offered to reflect perceived quality were deemed unpalatable.

Of far more interest to a burgeoning group of specialists, however, are the deals now emerging where the objective is overwhelmingly access to liquidity. “There are investors that don’t want to be forced to sell assets at the wrong point in the cycle. They want to maximize liquidity without forgoing future upside,” says Michael Hacker, global head of portfolio finance at AlpInvest. “They are therefore looking for a form of financing that isn’t overly punitive and so are putting their best assets forward.”

“We are effectively creating a temporary risk-transfer for the LP”

Fokke Lucas
17Capital

“We are definitely starting to see NAV solutions offered to LPs facing liquidity issues where the investor doesn’t want to sell at a double-digit discount,” adds Gerald Cooper, partner at Campbell Lutyens. “NAV financing, particularly where there is conviction that performance in the medium to long-term will be strong, can often make sense.”

The other advantage of NAV financing is that it is significantly easier and quicker to execute on than a traditional secondaries sale. “Transferring a book of 25 to 50 LP interests can easily take nine months,” says Lucas. “In a preferred equity or NAV deal there is no seller, so the investor of record remains the same. These transactions can be done in six to eight weeks, which is unheard of in the secondaries market.”

A NAV financing also sidesteps the bid-ask spread that is currently thwarting many secondaries sales because buyers and sellers don’t actually need to agree on value.
“If the NAV of a portfolio is 100, the secondaries market may offer 75,” Lucas explains. “We can structure the deal based on a NAV of 100. The cash we put in up front may be lower, we may not lend 75 against it. But it’s a much smoother discussion because as lenders there is no change of ownership and so no real need to come together on the value of the last dollar.”

Solutions providers

There is a growing pool of capital focused on providing LPs with this much needed liquidity solution. Secondaries players themselves are starting to bring structure into deals, for example by adding elements of downside protection.

“Secondaries market constituents are starting to expand horizontally rather than purely vertically, moving into new business lines, either offering preferred equity solutions within their flagship vehicles or creating dedicated pools of capital,” says Cooper.

Providers of genuine credit solutions are more of a rarity, however. “The reality is that banks just don’t understand the private equity asset class as well as those that play in the space day in and day out,” Cooper adds.

Secondaries players, however, are likely to be structuring equity, rather than providing a PIK coupon credit solution, says Hacker. “There are only a handful of providers in that genuine debt-like space.”

Indeed, the skills required to provide NAV loans as an alternative to an LP-led secondaries sale are hard to find. “You need the skills of a secondaries buyer in terms of assessing the portfolios, but you also need to have a credit perspective in terms of how you structure the transaction,” Hacker explains. “In addition, you need to know how to monitor that transaction over time. It is quite a bit more involved than a traditional secondary of a traditional loan.”

Future growth

True structured LP solutions specialization is unlikely to proliferate. After all, when the market is awash with liquidity and secondaries pricing is aggressive, the relative advantage of hold versus sell is significantly diminished, so this is largely a cyclical phenomenon.

“These deals don’t go away entirely in an up cycle, but it is certainly a cyclically-driven part of the market,” says Hacker. “When the secondaries market gets really hot, the rationale for holding on to those assets starts to go away.”

Lucas agrees: “We closed our first LP deal in September 2010 and have done them every year since but in upcycles when liquidity is high, LPs are often under-allocated to private markets and secondaries is more about selling non-core LP commitments. In those scenarios, investors are looking to clean up the books so a secondaries trade makes most sense.”

Even in a market driven by the denominator effect, Lucas believes secondaries sales will continue to dominate, simply because they are easier to explain internally. “The trustee of the pension fund, for example, will need to sign off and a straight sale is the known solution. The LP may already have made decent money, and this is an easy way of getting the liquidity required,” he says.

“Looking at it logically, however, NAV financing has a lower cost of capital than secondaries and the LP gets to continue to hold the upside and potential outperformance. That is all given up if they decide to sell. Further down the road, the LP can also unwind the NAV financing and revert to the status quo when public markets recover, and the investor might be underweighted in alternatives again. We are effectively creating a temporary risk-transfer for the LP.”

Lucas does believe, therefore, that this market will continue to grow, as the technology becomes more familiar and as advisers start to get deals under their belts. “It’s always easier to be a follower than a leader, and we do expect adoption to accelerate. We have numerous discussions with LPs and advisers, looking at NAV financings of more than a billion dollars per transaction.”

“We are seeing rapid growth that would make this a big market given the need for liquidity that is now driving secondaries,” adds Hacker. “Advisers are also becoming more sophisticated about structured options and there are more players starting to focus on this part of the market, meaning capital is priced more appropriately for the credit-like risk profile. One of the biggest issues that had been inhibiting growth up till now was that secondaries buyers were looking for credit-like risk with equity-like returns.”

“The growth of NAV financing is outpacing the growth of the secondaries market”

Darren Schluter
PJT Park Hill

Cooper agrees. “I think these solutions will continue to grow market share. Clearly in a difficult economic environment, NAV financing and preferred equity solutions are becoming more attractive due to the bid ask spread, but I think we will see this market expand even as conditions improve,” he says.

“LPs and GPs are increasingly sophisticated and are aware of solutions they can turn to at different points in the cycle, in order to optimize results. In many ways, it is a case of build it and they will come.”

“This market has more than doubled in the last two years and continues to see tremendous growth and acceptance, similar to the growth in the LP- and GP-led secondaries markets,” says Dave Philipp, partner at Crestline Investors.

Darren Schluter, managing director in the secondary advisory group at PJT Park Hill, adds: “We estimate 20 to 30 percent of secondaries transactions are currently utilizing NAV financing in some format, whether that is true NAV financing or a hybrid facility, which would indicate $25 billion to $30 billion in financing per year. The growth of NAV financing is outpacing the growth of the secondaries market as these structures have increased in adoption.”

The drivers behind NAV financing adoption are changing, however. Historically, financing was used to enhance returns across most secondaries strategies. This became more prolific when rates were low and competition for deals was high.

“But today’s macro environment is slowing asset sales, putting liquidity pressure on secondaries portfolios that are now looking to NAV loans to provide synthetic distributions to LPs and/or bridge timing mismatches between proceeds from asset sales and capital commitments,” says Philipp. “Another element driving more non-bank NAV activity is the growth of GP-led secondary portfolios, especially those that focus on single-asset continuation vehicles. As these portfolios begin to resemble private equity funds from a diversification perspective, non-bank lenders become more relevant.”

There are two main advantages of incorporating an NAV loan to support the acquisition of a secondary portfolio. First, the cost of an NAV loan should be less than the expected return of the secondaries portfolio, leading to a yield pickup should everything go to plan.

“A second advantage is that NAV loans can be used as a bridge to allow an adviser more time to pull together an optimal equity stack. Utilizing NAV loans as a bridge is more prevalent right now, especially in more complex transactions that take longer to complete,” says Philipp. “NAV loans are an increasingly valuable tool where there is an expected near-term exit within the portfolio. However, there is a risk that leverage can be harmful if the portfolio underperforms and the loan paydown is significantly delayed.”

But while NAV financing growth market has exploded, downward pressure on company valuations and lagged marks may constrain the number and volume of secondary transactions overall. “Our conviction is that these risks are likely to be outweighed by the market growth provided by the increased knowledge of NAV-based portfolio financings and expanded use of proceeds,” says Philipp.

And as demand for NAV financing grows, so does supply. “During the first quarter alone, PJT has touched base with at least 30 new entrants,” says Schluter.

Indeed, Crestline believes that the NAV financing market is still in the early-to-mid innings of development and will likely double in size over the next two to three years. The asset classes embracing NAV financing have expanded from buyouts to venture, growth capital, real estate and infrastructure, while the borrower base has expanded from traditional secondary portfolios to include family offices, trusts and foundations that have identified liquidity needs as well. “We expect the secondaries segment to grow in-line with the overall market for NAV loans,” Philipp says.

NAV lending in secondaries: How big could this get?

The market for NAV-based financings is estimated between $80bn and $100bn, with around $30bn of transactions completed in 2022 alone.

“This market has more than doubled in the last two years and continues to see tremendous growth and acceptance, similar to the growth in the LP- and GP-led secondaries markets,” says Dave Philipp, partner at Crestline Investors.

Darren Schluter, managing director in the secondary advisory group at PJT Park Hill, adds: “We estimate 20 to 30 percent of secondaries transactions are currently utilizing NAV financing in some format, whether that is true NAV financing or a hybrid facility, which would indicate $25 billion to $30 billion in financing per year. The growth of NAV financing is outpacing the growth of the secondaries market as these structures have increased in adoption.”

The drivers behind NAV financing adoption are changing, however. Historically, financing was used to enhance returns across most secondaries strategies. This became more prolific when rates were low and competition for deals was high.

“But today’s macro environment is slowing asset sales, putting liquidity pressure on secondaries portfolios that are now looking to NAV loans to provide synthetic distributions to LPs and/or bridge timing mismatches between proceeds from asset sales and capital commitments,” says Philipp. “Another element driving more non-bank NAV activity is the growth of GP-led secondary portfolios, especially those that focus on single-asset continuation vehicles. As these portfolios begin to resemble private equity funds from a diversification perspective, non-bank lenders become more relevant.”

There are two main advantages of incorporating an NAV loan to support the acquisition of a secondary portfolio. First, the cost of an NAV loan should be less than the expected return of the secondaries portfolio, leading to a yield pickup should everything go to plan.

“A second advantage is that NAV loans can be used as a bridge to allow an adviser more time to pull together an optimal equity stack. Utilizing NAV loans as a bridge is more prevalent right now, especially in more complex transactions that take longer to complete,” says Philipp. “NAV loans are an increasingly valuable tool where there is an expected near-term exit within the portfolio. However, there is a risk that leverage can be harmful if the portfolio underperforms and the loan paydown is significantly delayed.”

But while NAV financing growth market has exploded, downward pressure on company valuations and lagged marks may constrain the number and volume of secondary transactions overall. “Our conviction is that these risks are likely to be outweighed by the market growth provided by the increased knowledge of NAV-based portfolio financings and expanded use of proceeds,” says Philipp.

And as demand for NAV financing grows, so does supply. “During the first quarter alone, PJT has touched base with at least 30 new entrants,” says Schluter.

Indeed, Crestline believes that the NAV financing market is still in the early-to-mid innings of development and will likely double in size over the next two to three years. The asset classes embracing NAV financing have expanded from buyouts to venture, growth capital, real estate and infrastructure, while the borrower base has expanded from traditional secondary portfolios to include family offices, trusts and foundations that have identified liquidity needs as well. “We expect the secondaries segment to grow in-line with the overall market for NAV loans,” Philipp says.