New NAV loans are being made with some of the best interest coverage ratios at the portfolio company level that the market has “seen in a generation,” said a lender speaking at the Fund Finance Association’s European Symposium in late June.
Loan-to-values are thought to be “at the moment, conservative enough to withstand a fairly significant economic downturn,” said a fund finance lawyer.
Private credit ratings are helping insurance companies and other institutional investors into the market, where they can get improved risk-adjusted returns compared to direct lending, as well as triple-A rated debt that’s easier to wrap arms around, and higher yielding, than many asset-backed securities.
Underwriting standards “have changed dramatically” since the onset of the rising rate environment and the conflict in Ukraine, the lender said, speaking on behalf of his firm. “We always underwrite to hard downside cases, but… having been through [several cycles], this one feels different; feels tougher,” the lender said. “We are scrubbing extra hard.”
And lenders are increasingly collaborating to meet both borrower needs and investor yield targets, as well as demand for larger loans, further growing the market. In some cases, a sweet spot between “concentrated NAV” and “diverse NAV” – NAV loans backed by diverse portfolios of LP secondary stakes – means even banks, private debt funds and insurance companies can all collaborate on the same deal.
A second lender even cited a deal for a growth equity manager, backed by some 90, mostly not profitable, portfolio companies in which several kinds of lenders collaborated to produce a loan with a lower LTV than it’s interest rate – an example of how broadly relevant NAV facilities can be.
The advent of private credit ratings for NAV instruments more broadly has increasingly piqued the interest of insurance investors, which have been taking down bigger and bigger investments. One panelist said he’d recently completed a $4 billion facility that was completely taken down onto insurance companies’ books. Increasing inquiries from US, European and Asian insurers were also reported on the panel. Insurers are now also participating directly in the market, as Private Funds CFO has previously reported.
One panelist noted an unnamed borrower that even uses NAV facilities in lieu of leveraged loans for acquisitions, though “that’s quite a particular case,” he said. Normally, NAV loans are used post-investment period to make bolt-on or other accretive acquisitions, among other uses, while leveraged loans are used to make initial investments. But the levfin market has cooled off in response to macroeconomic events.
Further innovations abound. One panelist said that he’s seen expected credit loss, or ECL, structures using NAV financing, though he didn’t give further explanation.
“I’ve had conversations with each person on this panel about things like unitranche (loans) or back-levering structures,” the first lender, who works for a large credit manager, said. “I think we’ll see greater efforts to find ways to be both efficient from the borrower perspective, but also drive the right mix of returns and risk.”
Equity in the form of debt
But the breadth of applicability of and appetite for NAV facilities also includes structures that make some in the market “a bit nervous,” as one fund finance lawyer put it during the symposium.
That includes structures that could essentially give borrowers preferred equity but structured as a loan, whereas traditional secured NAV would have recourse to the underlying portfolio assets.
As Private Funds CFO previously reported, the loan is granted to a special purpose vehicle, which uses the loan proceeds to subscribe to preferred equity within the investment-holding vehicle. The terms of the pref and the NAV loan more or less mirror each other, meaning the lender’s security is over the SPV, with rights to the pref cash flows at the investment level.
These structures give a high level of flexibility to GPs while offering lenders superior yield to traditional NAV, and are “incredibly prevalent… at the mid-cap level and above across the market,” the fund finance lawyer said.
Correct pricing and thorough underwriting would be key to the appropriateness of such instruments, market players say. And the alignment between GPs and lenders in NAV facilities helps mitigate risk – no GP wants their portfolio to end up underwater. And the pref structure should mean that, in an instance where the portfolio was profitable but the borrower defaulted anyway, the lender would have access to the portfolio cash flows. Such a structure essentially mitigates the risk of a counterparty becoming a bad actor – say, a GP not repaying a loan because it is desperate to hit a return target – not of portfolio performance.
“Hybrid NAV” loans, as the lawyer called them, came about during the liquidity crises precipitated by the pandemic, when GPs – particularly the larger ones – “started to look very seriously at the terms that they needed to achieve in order to be able to get comfortable” with NAV and preferred equity-style solutions. German tax laws that prevent leverage going directly into the capital structure of an investment vehicle further spurred on the innovation, the lawyer said.
NAV borrowers have also taken out loans underwritten to the NAV of the whole portfolio and down-streamed proceeds to a single asset, as well – a practice one panelist said was “controversial,” since the price of the loan is presumably lower than it would otherwise have been.