Private Equity funds are holding many of their portfolio companies longer, which is increasingly requiring GPs to manage assets deeper into their harvest periods when there is less access to equity capital. While frustrating in normal times, this issue is especially painful in turbulent markets.
Fund-level or “NAV-based” loans are newer financing structures that offer mature funds access to incremental capital that can provide dry powder to protect their portfolios in later years. This financing comes at a cost, however, and should be used prudently.
Three liquidity options for ‘asset-rich/cash-poor’ funds
Funds seeking to tap this new capital should evaluate the cost and flexibility of various options and compare it to any potential reinvestment opportunity to ensure that proceeds are sufficiently accretive or protective. The range of transactions has grown dramatically over the past few years and has spiked recently as the market dislocation has uncovered a wider set of reinvestment opportunities and capital requirements.
Reinvestment transactions broadly fall into one of three categories:
- NAV preservation trades typically inject new capital into an underlying portfolio holding to cure a debt covenant breach, participate in a dilutive pay-to-play round or provide rescue financing. Case Study #1: A loan to a 2006-vintage fund with six active holdings, but no dry powder or access to additional LP equity. One of the underlying portfolio companies was experiencing financial stress and was in jeopardy of breaching its debt covenants. Crestline provided new capital through an NAV loan and the GP down-streamed the proceeds as equity into the stressed company, which preserved significant equity value by avoiding a default.
- NAV enhancement trades are frequently driven by a unique catalyst at an underlying portfolio company, which may include highly accretive follow-on capital used for acquisitions, growth equity, buying out co-investors at a discount and contributing development capital into hard-to-finance assets or projects. Case Study #2: Crestline completed a loan to a 2013-vintage fund in the food and beverage industry. The loan proceeds were used to buy out an existing LP that required immediate liquidity and was willing to sell its shares at a cost basis significantly below current NAV.
- Portfolio management trades include situations such as providing accelerated distributions to LPs, warehouse financing for acquisitions and subsequent syndications or bridge financing in between fund closes. Case Study #3: Crestline completed a loan to a 2003-vintage fund managing a buy-and-build strategy in traditional industries where investors were seeking some liquidity. The GP believed that there were high-probability paths to attractive exits in the medium term that could add more value than a forced sale. Our loan proceeds bridged this gap by providing some immediate liquidity to LPs while giving the GP more time to pursue an orderly exit. Some proceeds were also reinvested into one of the companies. The largest company has since successfully gone public.
Often more than one opportunity/requirement can be solved within the same loan structure.
Any potential liquidity transaction should have the following attributes:
- Accretion and preservation should measure probability-weighted outcomes versus the total cost of capital.
- Alignment across stakeholders is critical and is easiest to ensure in transactions that benefit all stakeholders, including GPs and LPs.
- Timely repayment needs to be accurately assessed. This means understanding the sources of repayment and the likelihood, control and timing of each. As the fund may experience positive or negative carry between the borrowings and reinvest opportunity, maintaining control over the duration is important to maintain accretion.
Not all leverage is created equal
It is important to distinguish between types of borrowings. Borrowings should be evaluated on two fronts to ensure that a transaction is not just another form of systemic leverage: expected duration and net effective leverage. Short duration bridge loans are deployed to pursue an immediate opportunity with the intent of repaying as soon as possible. This is in contrast to longer-dated leverage, which is designed to be outstanding for the life of a portfolio or individual holding. The other aspect is whether an NAV loan is adding more net leverage to a portfolio, or optimizing the existing leverage within a fund by refinancing loans at individual portfolio companies.
Fund-level and NAV-based loans allow a GP to better manage exposures through cross-collateralization and credit enhancement to pursue prudent opportunities. We believe the most successful financings are bridge loans that have a defined use of proceeds with an anticipated return on reinvestment that is significantly greater than the cost of capital accompanied by one or more likely options to pay down the new borrowing in a reasonable period of time.
Dave Philipp, CFA, CAIA, is a managing director of the fund liquidity solutions group and a senior portfolio manager at Crestline Investors. Crestline is a credit-focused institutional alternative asset manager with $10.1 billion in AUM.