‘Leverage is a sensitive topic for LPs,” says Carolina Espinal, managing director at HarbourVest Partners. But while skepticism was rife in the early days of the subscription finance market, when limited partners feared that the facilities were being used to manipulate optics and boost IRRs, there is now a broad consensus that the advantages in terms of treasury management outweigh any initial concerns.
A recent Investec survey showed that the frequency with which GPs are calling down capital from LPs has continued to fall, from an average of 2.3 times per annum in 2020 to a 10-year low of 1.9 times last year, alleviating pressure on back-office functions. It is also now considered best practice to report IRRs both with and without the facility, so investors have clarity on the impact of the line.
Nonetheless, LPs will sometimes seek to curtail LTVs and, more commonly, duration. “I have seen side letters where LPs are saying that although the LPA allows the GP to borrow for 24 months at 30 percent, they want the facility to be cleared down every 12 months,” says Ian Wiese, head of secondaries at Investec.
Typically, however, LPs will not object to the use of a subscription facility if the justification is strong and well communicated. “If you are a blue-chip GP which has demonstrated performance time and again, LPs will have no problem,” Weise explains. “Pushback only really arises when you have an underperforming GP suddenly using excessive lines in order to change the picture and to cover up performance.
“In terms of attitudes, you can draw a parallel with continuation vehicles. Those used to be called ‘zombie funds.’ Now they are called ‘trophy asset funds,’” Weiss adds. “Sub lines used to be seen as arbitrage – a tool for enhancing returns – now they are seen as an essential treasury management tool. If there is proper justification and the GP actively communicates that rationale to its LPs, then they will be happy to buy into it.”
LP attitudes to NAV finance are also evolving. Again, a clearly communicated rationale is key. “If there is a legitimate use of proceeds then LPs are reasonably relaxed,” says Thomas Doyle, head of NAV financing at Pemberton, who also points to the parallels with the continuation fund market, as well as dividend recaps on individual companies. “NAV financing is just another tool. If your performance is good and your communication is good, then LPs are likely to be supportive.”
“LPs are more likely to approve a transaction when they can clearly see that it is accretive,” agrees Dave Philipp, partner at Crestline Investors. “If they deem the risk to outweigh the potential return, however, they will rightfully challenge those deals.”
In fact, Zac Barnett, co-founder at Fund Finance Partners, believes LPs are more supportive of NAV lines than they are of subscription facilities. “With sub lines, the LPs’ own balance sheet and credit rating are effectively the collateral, whereas with NAV lines the collateral is the assets themselves,” he says. “I think they look at NAV financing more favorably because they don’t feel that they are carrying the load.”
Indeed, managers are increasingly looking to build the optionality to take out NAV financing into their LPAs and are, anecdotally, meeting little resistance. Furthermore, not only are investors comfortable with sponsors utilizing NAV loans, they are also actively looking to participate in the loans themselves.
“There is significantly more transparency and information available in the public domain around these products, which is helping LPs to better understand how they are used and what information to ask their GPs for,” says Wes Misson, head of fund finance at Cadwalader. “LPs are also looking to participate in these products directly. We began seeing a lot of this post-covid as GPs discussed various liquidity options with their investors. We are definitely now seeing this trend continue, which is perhaps no surprise, given the return profile and interest alignment on these trades.”