The Unicrunch — NAV lending, blood meridian of private credit

David Brooke

13 June 2023•4 min read

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All the pretty forces

In the world of modern financial markets, it’s easy to forget that private credit — and indeed credit in general — is at its heart a simple concept: lending money in order to receive it back at a later date, and charging interest.

There is a dizzying array of applications for this simple concept, however. The private credit universe is expanding into niche areas, like asset-based loan strategies, venture lending, and royalty and litigation financing. Some of these can generate double-digit returns, even on an unlevered basis.

You can now add Net Asset Value (NAV) lending to this growing constellation of strategies. It’s a new frontier in the $1.5trn private credit market; and while it is not necessarily a newly invented strategy, there are just a handful of names operating in the space.

It is a market of around $100bn in size (as of 2022, according to the Fund Finance Association). This is a fraction of the size of the global private credit market, but the expectation is that it will grow to $600bn by 2030.

The road (less travelled)

So-called NAV loans are secured by a portfolio of assets acquired by a private equity firm, rather than individual companies. Loan-to-value ratios are fairly conservative, generally in the 10%-25% range, with restrictions on how high the ratio can go over the life of the loan.

Because these loans are made at the fund level, they rank below the syndicated, bank-led or private credit facilities at the portfolio company level. In the event of a bankruptcy process, lenders at the company level are paid out before any value flows to equity holders; it is at this point that equity proceeds are funneled to the NAV lender, ahead of the buyout firm that owns the underlying asset.

Typically, PE firms may use a NAV loan a few years into the life of a fund. This may follow the introduction of a subscription line, which is first used to help fund the acquisition of assets — so that rather than constantly calling investors to draw down committed cash when investment opportunities arise, the fund manager has the liquidity ready and so can pounce quickly.

There are multiple reasons to get a NAV loan. They can fund underperforming assets that may need an injection of liquidity, help with early payouts to institutional investors, and boost the overall performance of the fund.

Today, a common use of NAV loans is to fund add-on acquisitions. The M&A slump means private equity firms are holding onto assets longer, and bolt-on acquisitions are becoming a useful strategy as sponsors seek new paths to growth.

Indeed, the depression in LBO dealmaking has filtered into private credit strategies. As 9fin recently reported, Ares’ and KKR’s business development companies reported that 80% and 87% respectively of deals completed in the first quarter were add-ons.

To complete an add-on acquisition, borrowers have various options in how they fund it. One is to source incremental debt at the company level (senior, or alternatively more subordinated types of financing such as junior debt, perhaps with payment-in-kind coupons); another is to tap an NAV facility.

Using the NAV facility avoids incurring extra leverage at the portfolio company. This is a particularly acute concern when rising rates have pushed coupons significantly higher, which in turn has hurt interest coverage ratios and driven some companies to default.

“NAV finance enables further investment in a way that keeps the economics in the fund, and avoids taking on excessive leverage at the underlying portfolio companies,” said Greg Hardiman, a managing director at 17Capital, in a recent interview with 9fin.

“You’re not hindering operating flexibility the way you might when you utilize traditional financing at the portfolio company level,” he added.

A country for old friends

Many might say there is nothing new under the financial sun, but today’s excitement for NAV lending makes it feel like a fresh alternative to the established world of direct lending.

A huge number of pension funds, insurance companies, sovereign wealth funds, endowments and family offices have buckets for private credit or alternative investment strategies that, of course, include direct lending products — and now many are now looking beyond traditional unitranche lending.

Senior direct lending is having an excellent moment return-wise, in the current rising rate environment. But to some investors, it is a product that they want to diversify away from, having already made their allocations. An investment in NAV lending can generate an unlevered return between 10%-15%.

“Many LPs are experiencing some degree of fatigue around direct lending, both intellectually and when it comes to allocating,” Roger Li, co-head of GP advisory at Briarcliffe Partners, said in an interview.

“Investors are curious people, eager to learn,” he added. “Many know direct lending inside and out, so are drawn to new strategies such as NAV lending, even if just out of curiosity.”