Lenders have an opening to offer GPs NAV loans, as well as a form of sub line/NAV hybrid, to fill funding gaps in their new continuation funds, which are caused by differences between the vehicles’ deal sizes and ticket amounts from secondaries investors.
The instruments represent small portions of activity in the GP-led funds market, industry sources tell Private Funds CFO. But market buzz suggests they are seeing increased interest from borrowers.
Linda Rowland, a managing director for the Ares Secondaries Group, says that there has been a recent shift in the type of leverage used by continuation funds, with a special type of hybrid gaining ground over instruments resembling subscription lines in the early stages of their lives.
“Eighteen to 24 months ago, we were seeing more commitment-backed facilities with a tenor of approximately 12 months,” she says. These facilities are often used after a deferral of the purchase price either at a later date or split into payment stages (for example, with 50 percent due in six months after the transaction and another 50 percent due at 12 months), with the lender often requiring the borrower to fund some equity at the first payment date, Rowland says. This process helps boost the IRR of the fund.
These “commitment-backed” facilities are similar to subscription lines, except that they are extended for use in a specific transaction and, in a default, lenders can only call capital from a CF’s investor fund entities, whereas a sub line lender has full recourse to the LPs themselves. They do typically feature other lender protections, however, including covenants on underlying assets, loan-to-value ratio caps, cash sweeps and a pledge of the bank account where distributions are deposited (required in only a minority of sub lines), Rowland says.
Now, she says borrowers are transitioning away from using these facilities alongside a purchase price deferral, and instead using hybrid facilities.
In a primary fund hybrid facility, a sub line would be drawn first, with capital calls reducing the underlying exposure to the borrowing base, after which the NAV loan portion collateralized by the underlying assets would kick in. In the hybrids offered for CFs, lenders typically seek both asset and full or partial unfunded support alongside the additional protections above, Rowland says. She added that some banks refer to these hybrid products simply as NAV loans with additional unfunded support.
Using hybrid financing to kick-start a continuation fund is a strategy that has only begun developing recently, says Martins Marnauza, a partner at private capital secondaries firm Coller Capital. While he is hearing more about borrowers using this technique for their funds, he caveats that there isn’t “hard data” available that shows the trend.
Leverage isn’t typically used in continuation vehicles at all, notes Holcombe Green, global head of private capital advisory at Lazard.
“At least our experience in the GP-led secondary market is that the majority of deals that we do are unlevered at the fund level in any way, and they’re all equity financed,” he says.
Green says that the use of fund financing in the vehicles is growing, including hybrids and NAV loans, but only marginally and from a small base.
Growing deals, shrinking ticket sizes
Studies from secondaries advisers show that continuation funds’ popularity boomed in 2022
Dollar estimates for GP-led volume overall in 2022 span from $43 billion, according to Campbell Lutyens, to $54 billion, according to Greenhill. The activity has increased steeply since 2017, when it was pegged between $14 billion (Jefferies and Greenhill) and $16 billion (Lazard and William Blair). Campbell Lutyens didn’t include historical GP-led volume in its estimates.
And continuation funds ranged from about 75 percent (Lazard) to around 90 percent (Campbell Lutyens) of 2022 GP-led volume. Single-asset vehicles were more common than multi-asset funds last year, with estimates spanning 40 percent of GP-led volume (Lazard) to more than 50 percent (William Blair).
The spike in popularity is in part because they allow GPs to provide LPs with liquidity before the end of a fund’s life. Others have used the vehicles to hold on to their best assets for longer, though skeptics say the increase may be due to a swoon in valuations beginning with the war in Ukraine and persisting as the global economic outlook remains uncertain.
At least one of these dynamics is sure to be driving the growth in deal sizes. “In the secondary market today, these opportunities can be quite large,” Rowland says about transaction sizes. “They can be multi-billion [dollars] in some cases.”
Deal sizes for continuation funds have increased due to growing market acceptance of the vehicle as liquidity alternatives to IPOs and M&A, Rowland says.
And yet lead and syndicate buyers have been cutting their commitment sizes to these funds, leaving seller GPs in a bind.
Rowland says the reductions are caused by several factors. One is because investors are cautious about adding concentration risk to already concentrated secondary portfolios, she says. Heavy deployment of investment capital into large GP-led deals in 2021 and into 2022 have left investors with some indigestion. Many GP-led secondaries buyers are looking to deploy an increased number of smaller investments in order to diversify their portfolios.
And the gloomy economic outlook doesn’t help.
“The macro environment and uncertainty in valuations – it’s causing secondary investors to be more cautious and generally more selective in their investment opportunities,” Rowland says.
That’s caused the fundraising environment to only get more and more difficult – another challenge for GPs selling continuation vehicles. Lastly, some secondaries buyers are holding on to some dry powder for an expected flood of LP interests this year, due to the denominator effect taking hold.
Enter fund finance
This growing gap between deal sizes and commitments is where some see a solution in fund finance.
Marnauza says that continuation fund managers can use hybrids, as well as NAV loans, to accommodate investors with limits on directly using leverage themselves and smaller investors whose cost of borrowing would be prohibitive, for example. The fund-level leverage allows managers to effectively magnify such investors desired commitments.
But there are challenges, here, too. Sources note that getting leverage isn’t always easy for concentrated portfolios of assets. Continuation funds may contain only one or a small handful of assets.
There are NAV lenders who specialize in highly concentrated portfolios, but they are relatively scarce, and expensive. Some say hybrids are the better option for single-asset vehicles, since the collateral includes buyers’ commitments, while most NAV loans are underwritten only to the assets in a pool.
Nate Walton, head of Ares’ private equity secondaries strategy, says investors tend to leverage themselves, anyway. He predicts that fund-level leverage in continuation vehicles will become more common, but never the norm, since most buyers manage their own funds of secondaries interests, and prefer to lever those, or simply want to keep leverage at the fund level they are investing in at a minimum.
LPs in secondaries funds, often private fund managers themselves, can also get more favorable pricing by taking on the leverage themselves, says Raj Senapati, managing director at HarbourVest. That’s because those investors have more diversified investor pools themselves than continuation funds, generally. Marnauza notes that this is one of the reasons why Coller takes on its own leverage.
Specialist lender 17Capital doesn’t extend standalone NAV loans unless the continuation fund has at least seven assets, says Gregory Hardiman, investment director. The firm offers preferred equity for vehicles with three to six assets.
But the firm does offer a special breed of NAV loan for some vehicles with one or two assets. This version is collateralized by assets outside of the continuation vehicle.
“In the case of a single-asset continuation fund, we may help the GP invest more, but our financing would require support from other GP-held assets outside of the CF, such as management fees or other GP commitments,” Hardiman says.
He cautioned that the specialized NAV loan is only used in certain instances, citing GPs’ tendency to make sizable transfer of carry into their vehicles.
“We would not expect it to become as widespread as other applications for NAV finance,” he says.
17Capital says that is because GPs may hesitate to pledge outside resources as collateral in addition to the crystallized carry they often roll over into the new fund.
Marnauza says there is opportunity for growth in this approach to the continuation fund market. Even if investors in a fund differ on their preferences and restrictions on leverage, he suggests dedicated sleeves could be offered to appease those who want exposure to leverage and those who don’t.