While traditional subscription line facilities are still used in the fund finance market, certain types of fund finance products such as net asset value (NAV) financings have emerged in recent years in Luxembourg and the Netherlands following on from the US markets.
NAV facilities were traditionally used by debt and secondary funds given their relative liquidity but are now frequently used by investment funds investing in all asset class types. These facilities allow them to borrow based on the value of their portfolio investments, providing them with flexible and efficient access to additional capital. NAV facilities may be used in various situations. Particularly when the undrawn investors' commitments are low or the fund investment period has ended and the fund seeks liquidity for investor distributions or add-on investments or, to provide additional liquidity for their distressed portfolio companies. For continuation funds, NAV facilities are used to finance the exit of limited partners not rolling-over. At general partner level, NAV facilities are typically used for working capital, investments, distributions and succession planning.
NAV facilities are described as "downwards looking financings" as lenders will have recourse to the value of the portfolio investments of the fund. NAV facilities are therefore separate from subscription line facilities secured by undrawn investors' commitments ("upward looking"), although there may be hybrid facilities simultaneously looking at the portfolio investments and the undrawn investors' commitments.
Structure
NAV financing arrangements can be structured as term or revolving loan facilities made available by lenders to an investment fund or a special purpose vehicle (SPV) held by such a fund.
The security package for NAV facilities is usually tailor-made and it depends on various considerations, notably:
- the fund's investment strategy and portfolio investments (all or part of the portfolio investments might be included)
- the borrowing structure (whether a fund or an SPV will borrow monies under the NAV facilities)
- regulatory and tax considerations
Lenders may seek recourse to:
- the bank account on which the distributions made by the portfolio investments are received
- the distributions claims owed by the portfolio investments
- the equity interests in a holding or portfolio company (or a combination of the foregoing).
That said, a pledge over the equity interests in a portfolio company is often not pursued given the complexities it may trigger on the vesting and enforcement of the pledge and, the limited risk of bankruptcy at fund or SPV level. Where the borrowing entity is the SPV and not the fund itself, a lender might require the fund to grant a pledge over the equity interests in the SPV or, a guarantee, or to enter into an equity commitment letter. The latter can be either in favour of the SPV or a lender, depending on regulatory and tax considerations.
An essential point when negotiating NAV facilities is the valuation methodology used to value the portfolio investments, as the borrowing base is determined by reference to the NAV of eligible investments. The main financial covenant will be the loan to value (LTV) test, which requires that the amount of debt drawn under the facilities does not exceed a given percentage of the NAV of the fund's underlying investments.
Due diligence
In addition to the security package, the terms and provisions of NAV facilities should consider certain aspects of due diligence issues and regulatory matters.
In respect of the due diligence process, the constitutional documents of the fund (notably the limited partnership agreement or equivalent) or the SPV should be carefully reviewed. In particular, the limitations on borrowings in the limited partnership agreement and other fund documents, the possibility for a fund to borrow and use leverage, the permitted duration for borrowings and, the use of proceeds. Assessment of the constitutional documents must consider the specific features of the relevant NAV financing.
Furthermore, the constitutional documents must expressly allow the fund or the SPV to give security interests to secure its own obligations or to secure or guarantee the obligations of the SPV. Regulatory or tax considerations may again be relevant.
If the security package also consists of pledges over the equity interests in the holding and portfolio companies, the constitutional documents and shareholders' arrangements of those companies may contain restrictions in relation to the transfer of equity interests. These arrangements may include drag/tag along rights, specific board/committee consent, pre-emptive rights and other transfer restrictions. It should also be assessed whether any transfer of the equity interests could have implications on the regulatory or tax status of the portfolio company.
Another point of attention is to determine whether the granting and/or the enforcement of a pledge over an equity interest securing a NAV facility may trigger the application of any change of control provisions under the financing arrangements at portfolio company level. If security is granted over equity interests, the risk that a change of control is triggered upon enforcement of the security, is typically taken by NAV facility lenders and dealt with upon enforcement with the lenders at portfolio company level. Dealing with this beforehand is burdensome, often not feasible and frequently the main reason security over equity interests in the portfolio companies is not included in the security package.
Finally, assessing existing subscription line financings at fund level and external debt financing at portfolio company level is a crucial consideration for lenders under a NAV facility. Understanding the terms of existing financing arrangements is essential to evaluate the applicable covenants and limitations, the permissibility of upstreaming cash and the potential for leakage. Thorough review of finance documents and consideration of these factors, is vital for lenders to ensure a comprehensive understanding of the overall risk profile of the NAV facility.
Regulatory considerations
EU investment funds are usually established as alternative investment funds (AIFs) in accordance with Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulation (EC) No 1060/2009 and (EU) No 1095/2010, as amended (the AIFM Directive). Any vehicle qualifying as an AIF must appoint an alternative investment fund manager (AIFM) responsible for ensuring portfolio management and risk management services.
Regulatory matters should also be considered, given that in certain situations, NAV borrowing arrangements may constitute leverage under the AIFM Directive. In the case of such leverage, NAV facilities should be included in the leverage calculation by the AIFM.
Sub threshold AIFMs
Any leverage at AIF level may affect whether the AIF must appoint an authorised AIFM and a depositary.
The management or marketing of AIFs by 'large' AIFMs triggers the obligation to obtain a license, subject to certain exemptions and 'grandfathering' rules. AIFMs are categorised as 'large' if they directly or indirectly manage portfolios of closed-end unleveraged AIFs with assets under management of €500 million or more. Below this threshold, the AIFM can benefit an exemption from the license requirement. However, when the AIFs are considered leveraged, the threshold for the AIFM's obligation to obtain a license decreases significantly to €100 million. Therefore, managing "leveraged" AIFs substantially lowers the threshold for AIFMs to fall under the license requirements in the Netherlands and Luxembourg.
When structuring NAV financing for AIFs managed by sub threshold AIFMs, the abovementioned consequences should carefully be taken into account.
Licensed AIFMs
A licensed AIFM will be required to set a maximum level of leverage and a limit on the reuse of collateral or guarantees that could be granted under a leverage arrangement. This must take into account the type of AIF, its strategy, the sources of leverage, the relationship with financial services institutions that could pose systemic risk, counterparty exposure and the extent to which the leverage is collateralised. In addition, it has to apply a liquidity policy. If the license of the AIFM does not include managing leveraged AIFs, the AIFM should make a filing with the regulator in connection with an AIF entering into a NAV facility, with a waiting period attached thereto.
As safekeeping functions must be separated from management functions, a licensed AIFM must ensure that a depositary is appointed for the AIFs it manages. The AIFM Directive states several obligations regarding the safekeeping and supervision of the assets, day to day administration of the assets and ongoing due diligence on compliance with the investment policies. Due to monitoring of the compliance by an AIF with the leverage limits, the AIF depositary should be involved in a NAV financing.
Accordingly, an AIF entering into a NAV facility which qualifies as 'leverage' under AIFMD likely has regulatory consequences. Leverage is defined under the AIFM Directive as any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means. According to the AIFM Directive, exposure contained in any financial or legal structures controlled by an AIF should be included in the calculation of exposure where those structures are specifically set up to increase the exposure directly or indirectly at AIF level. It is important to note for investment funds, that leverage existing at portfolio company level should not be included in the leverage calculations, if the AIF does not have to bear losses beyond its investment in the financial structure that is used to acquire the investment.
Conclusion
In summary, NAV facilities have emerged as a strategic tool for investment funds, providing them with flexible access to capital based on the value of their portfolio assets. Thorough due diligence and consideration of regulatory requirements are essential to structure and execute NAV facilities successfully while mitigating risks. These financing arrangements offer funds greater financial flexibility and efficient liquidity management, enhancing their ability to accommodate limited partners and pursue investment opportunities.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
