In many respects, the current macroeconomic backdrop is creating an opportunity for NAV finance. “Higher interest rates, inflation and a decline in public market valuations have led to a weak exit environment for private equity sponsors,” says Jamie Mehmood, partner and head of fund finance advisory at Deloitte. “This is dampening the ability of LPs to re-up to successor funds, slowing fundraising significantly and making rolling closes the new normal.
“Consequently, sponsors are looking at ways to either return capital to LPs and/or to hold assets until a more favorable exit environment opens, while continuing to add value to those assets. This potent brew means sponsors and LPs are having to consider alternative sources of capital and liquidity to meet the challenges of the current environment. NAV financing is one of these options.”
But high interest rates have undoubtedly led to a significant increase in the cost of NAV facilities as well. “NAV loans are primarily floating rate instruments and so will move with base rates in the same way as traditional corporate financing,” says Greg Hardiman, managing director at 17Capital. “We have also seen some movement on spreads, as we have in the broader credit markets.
“However, having financing costs going up a couple of hundred basis points doesn’t take away from the thesis that a GP may have on an add-on opportunity where there is clear visibility on returns. Cost of capital is a factor, but, if anything, it is a factor that is making GPs look more closely at NAV financing given the greater flexibility to utilize PIK interest, which can ultimately reduce the cash burden for portfolio companies amid a period of higher rates.”
A higher cost of capital is more problematic when it comes to the use of NAV finance to accelerate distributions, however. Of the three primary use cases for NAV facilities at a fund level, Jonathan Harvey – Investec’s head of relationship management, fund solutions – believes there is only one that makes sense in the current environment.
“LPs are having to consider alternative sources of capital and liquidity to meet the challenges of the current environment”
Jamie Mehmood, Deloitte
“A NAV line can be used to protect portfolio company positions, where asset-level financing isn’t available,” says Harvey. “But, as we saw during covid, banking is now highly relationship-led and lenders are generally willing to give companies the time they need to weather a storm such as this. A NAV line can also be used to distribute capital to LPs, in order to support a new fundraising.“But the cost of a NAV loan is now higher than the 8 percent hurdle rate, making that uneconomic. So, for me, the only use case that remains valid today is value creation. It can make sense to take on an expensive form of financing if you know the returns that will be made in the long run will be higher.”
Khizer Ahmed, founder and managing member of Hedgewood Capital Partners, also believes that use cases have shifted as a result of the macro environment. “Twelve to 18 months ago, it was very common to find secondaries funds deploying NAV facilities to accelerate distributions to LPs, for example, in order to support the raising of a new fund. That use case is more challenging today because of the cost of facilities. SOFR plus 3.5 or 4 percent today brings us to 8 to 8.5 percent, which is a fairly hefty cost.”