A “fundamental shift” is taking place in a niche corner of the fund finance market, according to Zachary Barnett, managing partner at advisory firm Fund Finance Partners in Chicago, who has arranged hundreds of fund finance transactions. Of those, more than 50 have been net-asset-value loans over the course of his career, he says. But the number is growing, fast.

The economic sclerosis brought on by the covid-19 pandemic is giving a small band of ‘concentrated NAV’ lenders an expanding footprint, as banks pull back on new lending and funds look both to protect their portfolios and prepare to take advantage of whatever new investing landscape emerges from the crisis. The result is that these lenders, who have so far focused largely on mid-market funds, are seeing a flood of demand from their traditional target base. But they are also seeing their menu of options expand.

That is providing a kind of supercharged proof-of-concept moment concentrated NAV lenders have been waiting for, albeit against a background no one would wish for. In January, NAV-loan focused Hark Capital’s Doug Cruikshank told Private Funds CFO: “At some point, we will hit a downside scenario … and, in general, portfolios will take more time, not less, to come to fruition. In those cases, the sponsors will want the optionality and the capital we provide.”

Less than two months later, Cruikshank was proven right. In addition to the inquiries they typically receive, larger, more diverse portfolios and higher quality sponsors are coming their way, says Cruikshank. He describes the firm’s strategy now as a “flight to quality,” while valuations remain so uncertain.

“The biggest unknown is how much of our pipeline will convert into transactions in Q2 and Q3”
Dave Philipp
Crestline Investors

Hark is not alone. At Crestline Investors, managing director and senior portfolio manager Dave Philipp says dealflow is up some five to 10 times historical levels. At Investec in London, banker Matt Hansford says he’s looking at more than one new concentrated NAV deal a day. Silicon Valley Bank global head of fund banking, Jesse Hurley, says his team has seen a year’s worth of deals in two months. Pierre-Antoine de Selancy, managing partner at 17Capital in London, told sister title Secondaries Investor in late March that the firm saw $2.5 billion in combined NAV loan and preferred equity dealflow – a quarter of 2019’s total – in two-and-a-half weeks. A week later, that number hit $3.5 billion, saying then that the pace was only increasing. In April alone, the firm saw some $4 billion in potential deals.

Who, what, when, why?

With the turmoil in markets caused by the covid-19 pandemic, GPs and LPs alike are facing strains on liquidity. GPs are propping up their portfolio companies, many of which have already fully drawn their revolvers and whose cashflows are still frozen, with injections of cash from wherever they can get it – existing fund equity, capital call lines, LP commitments. But with the GP-led secondaries market on hold as multiples and EBITDAs remain unclear, banks becoming more cautious in how much they lend and to whom, and no end yet in sight for the confusion thrown upon economic activity, firms are looking more closely at rarer forms of fund financing.

Both concentrated NAV lending and preferred equity are considered niche forms of that market. While the latter has been around since before the crisis, concentrated NAV is relatively new. Traditional NAV lending, where banks are more active, tends to focus on funds with diverse portfolios (often large secondaries purchases, for example).

In concentrated NAV, lenders make a loan to funds that are usually somewhere mid-way through their lifecycle, with generally 10 or fewer assets left in the portfolio, and most equity already deployed. Structures differ and maturities are flexible, but loans generally come in the one to five-year range, with bullet payments, often structured as payment-in-kind (allowing the borrower to preserve cash on hand, while being expensive enough to incentivize borrowers to have a goal and a timeline for the capital, and to stick to it). Lenders often have payment priority to LPs, or get seniority to all distributions if the loan defaults. Loans can be cross-collateralized with some flexibility to pull assets out of the pool, or not – it’s a highly bespoke market.

New faces come knocking

Not only are more of these lenders’ target customers knocking at their door; bigger funds and new kinds of opportunities are flowing in, says Zachary Barnett of Fund Finance Partners. “Deals with lower LTVs, say in the 10-20% range, which would normally be attractive to banks, are now being shown to alternative lenders as many banks have hit pause on this type of lending.”

NAV lenders tend to get most of their demand from the smaller end of the mid-market, says Tom Glover of Investec. “Now demand is starting to come from larger middle-market players,” he says. “We have more than half a dozen active inquiries from US mid-cap funds whose current fund size is in the $2 billion-$5 billion area.”

In part, NAV lenders say the growth in dealflow also represents a growing understanding of the product. “It might cost 8-12 percent, depending on the situation, but you can pay it off,” says Glover. “If you bring in something like equity co-investment, that’s permanent dilution, which is very expensive and return-lowering.”

In May, nearly all of the lenders reported a shift upward in the quality of potential borrowers and deals that might satisfy their return targets. “It’s showing a growing acceptance of this kind of financing, which is why it seems to be migrating upwards in terms of fund size and diversity,” says Doug Cruikshank of Hark Capital, who adds that he’s seen both GPs and LPs become more comfortable with their product. “GPs are even more willing to go to back to their LPACs if for some reason it’s not immediately allowed in their LPA,” he says. “And LPs from what we’re seeing are particularly favorably disposed toward this type of solution now, because it provides the portfolio with not only defensive capital for liquidity but also potentially offensive capital to do tuck-ins at arguably a good time to be a buyer.”

All of the NAV lenders also reported that while proposed transactions were primarily defensive in nature, they almost ubiquitously included some opportunistic aspect. “Almost uniformly, people who are asking for defensive capital are also asking for some element of delayed draw capital to play offense as well,” says Glover. “There is practically nothing in my pipeline that is purely defensive.”

That somewhat unique dynamic may be spurring some lenders to think creatively. “Those [delayed draw requests] are challenging because undrawn capital generates substantially lower returns,” says Glover. Some NAV lenders can already offer delayed draw components on their loans, and Glover says Investec is trying to craft solutions to satisfy unique demands like this and still meet its targets. That sentiment is echoed by Jesse Hurley of Silicon Valley Bank. “We’ve seen a much wider variety of asks, but we’re still finding creative ways to structure support for our clients,” he says.

Credit funds are also starting to trickle in, says Dave Philipp of Crestline Investors, who says the firm is in early talks with some of those borrowers. Historically, the firm’s cost of capital was too high for credit funds, but many are now being turned down by their traditional bank lenders, and are searching for alternatives. Many credit funds are reportedly urgently in need capital, breaching LTV covenants or struggling under the liquidity pressure brought on by corporate borrowers’ mass revolver draw-downs in March.

But they aren’t the only new, or at least rare, kinds of borrowers NAV lenders are seeing. Crestline reports an increase in inquiries from real estate funds. Two lenders said they’ve either heard from GPs looking to finance a co-investor who couldn’t, or wouldn’t, meet recapitalization capital requests, or to finance their own pro rata co-investment where they are short on cash.

And Investec is even seeing some LPs look for NAV loans backed by their unfunded commitments as a backstop should distributions remain low for an extended period of time even as capital calls continue. “We’ve gotten several inquiries from LPs looking for a line of credit to protect their overcommitment strategies,” says Glover.

“Sponsors are in exploratory mode,” Philipp says, speaking of the private funds market more broadly. “Lots of people are looking to figure out if this is the right capital source for them.”

Borrowers are usually funds that need to make capital injections to portfolio companies, make distributions to investors in the case a realization event has been delayed, boost portfolio company growth or make additional acquisitions, among other things. The loans are more expensive than most bank financing, being backed by more concentrated, sometimes riskier portfolios. That said, a handful of banks other than Investec and Silicon Valley Bank are or have been active – if infrequently and with varying risk appetites – and concentrated NAV lending tends be done by a different business line than diversified, like the leveraged finance or special situations desks. Keeping in mind significant differences in lending styles, multiple market sources say the odd bunch of banks that have been active in the market include Goldman Sachs, JPMorgan, UBS, Nomura, Macquarie, National Australia Bank, and Commonwealth Bank of Australia.

Non-bank players are fewer, but more active. They include the firms mentioned above, as well as Origami Capital Partners in Chicago. Concentrated NAV loans can have interest percentages that run anywhere from the middle single digits into the teens.

Because of those potentially high rates, many funds tend to exhaust their other liquidity options first: capital calls, qualified borrower joinders within credit agreements (subscription line clauses that allow a portfolio company to become the effective borrower), hybrid lines, among them. But the concentrated NAV sector is attracting new interest under the circumstances.

Jocelyn Hirsch, partner at Kirkland & Ellis in Chicago, says interest in NAV loans, both diversified and concentrated, has rallied. “We are seeing funds that weren’t always interested in NAV lending becoming interested, because they have liquidity issues and don’t necessarily want to call capital because they think this is short-term, or maybe the fund is at the end of its life.”

Banks rein it in

But fund finance professionals say banks have been ‘pencils down’ on many of the more diversified plays they are traditionally active on. Indeed, two sources said in March that a large secondaries purchaser was rejected for a diversified NAV loan by their relationship lender, putting up 100 percent of the equity for the buy (that report could not be verified, but secondaries deals are sometimes done with high LTVs of more than 50 percent, making them less attractive in times of uncertainty). Since then, banks have reportedly pulled back even more, diverting dealflow to alternative sources of capital.

Banks – infrequently and (apparently) quietly active in concentrated NAV – are largely busy assessing their current exposures and prioritizing their best relationships, even in areas where they are highly active, like in subscription credit lines, diversified NAV and hybrid credit line lending.

“Getting leverage for debt purchases is very much top of the list for many firms given the current environment”
Jocelyn Hirsch
Kirkland & Ellis

“We’re seeing increased pricing, funds are becoming more lender friendly, tenors are shortening; but banks are prioritizing resources and being very selective,” says one sub-line lender whose bank also provides diverse NAV facilities and, on occasion, concentrated NAV loans. Banks widely reported big growth in loans in the first quarter, with some being said to have effectively reached capacity in certain sectors.

“The thing that we’re running into is that these banks are understandably busy with their existing trades and existing relationships. There are new deals getting done, but it’s certainly not as fast as many of our clients would like,” says FFP’s Barnett.

Indeed, most of the lenders speaking with Private Funds CFO in March were busy looking at deals from existing clients who were inquiring about rescue capital, curing covenant breaches, buying out LP interests in their own funds to facilitate their liquidity needs or for working capital (in some cases also for ‘accretive’ growth capital).

Cruikshank told Private Funds CFO at that time that many of the sponsors were being proactive, anticipating severe stress: “Sponsors know there are going to be some issues, and what they’re trying to do in a very thoughtful manner – and actually I’ve been really impressed with how on it everyone’s been – they’re trying to assess potential weak spots in their portfolio, in advance of them becoming weak spots, and trying to come up with some contingency plans to try to handle what they think could be inevitable.”

By May, that stress had only intensified. “A lot of the in-bound inquiries we’re getting are because underlying portfolio companies are having stress against their bank lines,” says Crestline’s Philipp.

New clients, new plays

“We’re beginning to see the fruits of our marketing efforts,” says Tom Glover, North American fund finance head for Investec. Two of the people speaking to Private Funds CFO indicated that they have taken calls from investors considering, or are considering themselves, taking down loans big enough to syndicate between themselves. Many NAV lenders will offer direct co-investment to their own LPs and other non-traditional market players on larger loans. And GPs wanting to take out NAV financing might find offering a piece of the facilities to their LPs an attractive incentive.

“Allowing an option for LPs in a fund to take a portion of the facility is a really good way of a GP providing a very fair and open option to its LPs on these,” says Investec’s Hansford.

“It’s harder to get your arms around all these valuations. You can protect yourself to some extent when you focus on higher-quality franchises and portfolios”
Doug Cruikshank
Hark Capital

Many potential borrowers are looking for a mix of defensive and offensive capital. Crestline’s Philipp says: “We’ve seen sponsors come to us trying to provide new capital to their portfolio companies to pursue a variety of market driven opportunities. Several funds are looking to deliver some equity gap financing in order to close an acquisition as the underlying debt capital market has pulled back or seized up, right now.”

Investec’s Hansford says others have their eyes out for “bolt-ons and tuck-ins for the portfolio to be really value-creative and maybe differentiate themselves versus their peers, who they think will be more focused on defending value.” He adds that many of the conversations he’s having are with regard to funds from 2015-17 vintages.

Many funds, unable to do much in the way of new transactions while pricing is so unclear, are taking closer looks at their portfolio companies’ debt, and considering buying it out – yet another arena where concentrated NAV lenders are eager to play. Hark has entertained interest from potential borrowers on this front, Cruikshank says.

Crestline’s Philipp says his firm is also active on this front: “We have done several deals where we are extinguishing portfolio company debt with equity or buying the debt itself or issuing new debt.”

“Getting leverage for debt purchases is very much top of the list for many firms given the current environment,” says Kirkland & Ellis’s Hirsch. Funds are looking to buy the debt of their own portfolio companies, or even that of companies that they have previously done due diligence on, but didn’t close. “Even PE shops that haven’t looked at purchasing debt as an asset class before are getting interested. Some firms are setting up special situations funds or annex funds on an emergency basis to enable them to purchase debt.”

Supply and demand question

Alternative lenders like those active in concentrated NAV and preferred equity are highly selective. Due diligence on these deals is not a quick and easy task for any player. Concentrated NAV deals are bespoke, and approaches to assessing the borrowers vary, from the amount of emphasis placed on the residual value of the underlying portfolio, to the amount laid on the history and performance of the GP, to the accessibility of the assets in the case of a default in cases where the loans are secured.

“Our experience has proven that the quality of the organization matters much more than the theoretical quality of the portfolio,” says 17Capital’s de Selancy, who says manager track record is the top underwriting priority, followed by a portfolio company-by-company assessment and scenario analysis of cashflows and leverage.

“We’ve seen a much wider variety of asks”
Jesse Hurley
Silicon Valley Bank

Hark’s Cruikshank agrees that manager quality is all-important, especially now. “It’s harder to get your arms around all these valuations,” he says. “You can protect yourself to some extent when you focus on higher-quality franchises and portfolios.”

The uniqueness and complexity of these kinds of deals mean a low deal-flow-to-transaction rate, at least while the present supply and demand dynamics persist. De Selancy says the firm only transacts on about 5 percent of dealflow, and this year it’s more likely to be around 2 percent. Demand is also causing increased pricing – in 17Capital’s case by around 500 basis points, Selancy says (17Capital primarily provides preferred financing, but also does some NAV lending, depending on customer requirements). “It’s a moving environment, but the scarcity of capital is driven by the fact that demand has gone through the roof.”

By early May, all of the lenders Private Funds CFO spoke to had either completed a handful of transactions since the crisis began or were in advanced stages. But with the pandemic causing almost ubiquitous stress on businesses’ cashflows, demand has already far outpaced supply.

Crestline’s Philipp says the firm is still focusing on inbound inquiries, making sure prospective borrowers understand the firm’s risk appetite, terms and potential structure. “The biggest unknown is how much of our pipeline will convert into transactions” in the second and third quarters, he says.

“These alternative lenders are providing much-needed financing to the market,” says FFP’s Barnett. “But to be honest, there’s not going to be enough of that to plug the gap for many of the 4,000 private fund sponsors that are going to be in search of liquidity, some for accretive and others for protective purposes.

“Allowing an option for LPs in a fund to take a portion of the facility is a really good way of a GP providing a very fair and open option to its LPs on these”
Matt Hansford
Investec

“If there were more of them now, we’d all be better off, because they are providing the types of liquidity, rescue financing and short-term gap financing that banks aren’t likely to be able to execute on over next six to 12 months. This is the type of efficient deployment of capital the market needs right now.”

What remains to be seen is whether concentrated NAV financing proves worth the cost for those funds tapping it for defensive liquidity – this is this market’s first real test. And this unprecedented crisis brings with it unprecedented uncertainty. How long will lockdowns last? How effective will government programs and aid prove to be? Should the global economy return to some kind of normalcy, could it precipitate a second wave of covid-19 and a return to widespread lockdowns?

“If that happens, all bets are off in terms of how much liquidity will be needed,” says Cruikshank.

Origami awaits

As lenders like Hark target higher-quality deals and borrowers, some of the riskier, higher-yielding opportunities may be left on the table. That’s the kind of fare Origami seeks out

“Where we differentiate is in what we’re comfortable with from a concentration perspective and to an extent our LTVs can generally be higher than some of the other guys,” says Truls Porter, senior vice-president of originations at Origami in Chicago. He and Origami partner Julie Klaff say they too are seeing higher-quality deals at their desired return, but their interest lies more in what’s yet to come. “We expect the pace of transacting will pick up in speed over the second half of the year,” says Klaff. “Stuff is just starting to shake loose and you’re just starting to see the effects of what happened in late March to May.”

One focus right now is on credit funds, says Porter. “We’re doing a lot of work on getting a lay of the land of the credit funds themselves. A lot have used leverage, and there could be interesting things to come out of it.”