Private equity is suffering from a dearth of distributions. The M&A and IPO markets are both ostensibly shut and yet investors urgently require capital back as they find themselves significantly overallocated to the asset class and unable to commit to new funds.
Solving this conundrum has historically been the remit of the secondaries industry. But in some situations, LPs are unwilling to take the hit on pricing that selling in the secondaries market currently involves. They are also keen to maintain relationships with sponsors. This is where NAV financing comes in.
“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.”
Gerald Cooper, partner at Campbell Lutyens concurs: “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. 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 easier and quicker to execute than a traditional secondaries sale. “Transferring a book of 25 to 50 LP interests can easily take nine months,” says Fokke Lucas, partner at 17Capital. “In a 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.”
NAV financing also sidesteps the bid-ask spread that is currently thwarting many secondaries sales because buyer and seller 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.”
However, the use of NAV financing as an alternative to secondaries sales is likely to be 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.”
“There are investors that don’t want to be forced to sell assets at the wrong point in the cycle”
Michael Hacker, Alpinvest
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.
“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.”