Subscription line financing is now a well-established tool in the armoury available to an investment fund. It can bridge short-term financing needs, allowing funds to move quickly with successful bids for investments, and ensure that the day-to-day costs of running the fund are not dependent on a stream of small drawdowns from investors. Subscription line financing is secured against the contractual obligations of investors to fund their undrawn capital commitments, often described as “looking up” recourse.
By contrast, net asset value financing, “looks down” to the portfolio of investments acquired by the fund. The term “net asset value” arises from the fact that the investments of private equity, real estate or infrastructure funds often also have individual investment level leverage, and the pool of investments that is relevant for a NAV financing is the net value after deducting the leverage for each investment. But NAV financing is also the term sometimes used for financing provided to other kinds of Fund such as secondaries funds or real estate funds.
While NAV financing has been around for a while, there has been a noticeable increase in completed transactions in this area since the start of the covid-19 pandemic, both in Europe and the US. At the start of the pandemic, macroeconomic uncertainty contributed to the reticence of fund sponsors to call capital from their investors, leading those sponsors to seek liquidity from elsewhere for their investments. In addition, given the “look down” recourse to the underlying portfolio of investments, NAV financing is an attractive source of liquidity for end-of-life or near-end-of-life funds that have called and deployed all or a significant portion of their investors’ capital commitments, but which now have an established portfolio of investments.
Current global uncertainty in economic markets and inflationary pressures have constrained the balance sheets of many banks that could have been used for subscription line financing. In addition, and importantly, fund investors have to deal with the so-called “denominator effect” which means they cannot make commitments to new funds until they have received distributions from investments in existing funds. As a result, fundraising for 2023 will be lower than it was in 2021 and 2022.
As a result, the availability of and need for subscription line financing has reduced, producing a knock-on effect with the demand for NAV and hybrid financing increasing. The latter uses elements from both subscription line and NAV financing, often with an element of both “look up” and “look down” recourses. A number of alternative lenders such as credit funds are now attracted to the higher returns that are available from NAV and hybrid financing, together with the fact the loans under NAV facilities are typically drawn for longer periods of time compared with loans under subscription line facilities. Many banks in the fund finance market that traditionally provided only subscription line financing are now branching out to NAV and hybrid financing.
Back-leverage or loan-on-loan financing is finance provided to a credit fund where the recourse for that finance is the portfolio of loans owned by that credit fund. In reality, this is another form of NAV financing in the widest sense of that term, but, since the loan is the asset for a portfolio of loans, there is no “net” asset value as there is no asset level leverage. Like other forms of NAV financing used appropriately and at the right price back-leverage can enhance internal rates of return of a credit fund.
Another factor likely to feature in future trends is that to address regulatory and capital retention issues, both bank and alternative lenders are keen to explore obtaining a rating of the debt they provide, since suitably rated debt should result in a lower capital requirement for that lender. Obtaining ratings should also facilitate a lender’s ability to syndicate the facility to certain market participants such as insurance companies. A number of rating agencies have recruited fund finance specialists to grow this side of their business and we understand that a growing amount of NAV debt is now rated.
Finally, while not yet credibly a future trend, one current discussion is whether NAV financing can be provided using a term loan A and term loan B facility, or a unitranche facility, with banks and alternative lenders combining together to provide such facilities. The idea is that a more traditional bank would provide the term loan A senior facility (or the more senior unitranche debt), with the alternative lender providing the term loan B subordinated facility (or the subordinated unitranche debt). While uncommon, this structure may develop and would reflect to some extent the historic development of unitranche in the leveraged finance market.
The reduction in fundraising, restricted bank balance sheets available for subscription line facilities, and a slowdown in exits for sponsors’ investments, should all lead to a significant continued growth in the demand for NAV and hybrid facilities during 2023 and beyond.
Leon Stephenson and Bronwen Jones are partners at law firm Reed Smith, based in London