We structured the NAV loan (Net Asset Value loan) so it can be part of a hybrid Active Managed Certificate (AMC), without needing a third party to provide the loan to the General Partner (GP) in a private equity fund. This setup avoids conflicts between the GP and Limited Partners (LPs) and ensures no one creditor is favoured in the capital structure since the loan is managed by agreements in side letters and the Limited Partnership Agreement (LPA).
The LPs’ Perspective
Through our AMC setup, we explore ways to create liquidity in private equity (PE) funds. The use of NAV loans became common during and after COVID, as GPs needed to keep making payments to LPs without lowering the fund’s quality. A hybrid AMC helps by providing liquidity alongside the committed capital. PE firms often need cash, especially as traditional financing has become more expensive and selling investments has gotten harder. NAV loans help fund new investments, refinance old debt, and sometimes, controversially, fund early payouts to LPs. The NAV loan market has grown 25% over the last 5 years, with over $150 billion in outstanding NAV loans in the U.S. alone. LPs have raised concerns about using these loans to fund early payouts, as it can artificially boost a fund’s performance (IRR). NAV loans rank higher than LPs in the capital stack, meaning lenders get paid first. However, in a hybrid AMC with well-designed side letters, some of these issues are addressed fairly for LPs. Research shows NAV loans are being used both to grow the fund (which LPs prefer) and for early payouts.
The GP’s Perspective
With the secondaries market becoming more active, GPs have their own views on NAV lending. NAV loans have been around for over a decade and are now widely used, marking a shift in private equity. In the U.S., there are about 28,000 private companies valued at $3.5 trillion. GPs use NAV loans as a key tool, especially in tough times like the COVID-19 crisis or the 2008 financial crisis, to maintain strong performance during challenging economic conditions. The best use case for GPs is to drive capital growth, while the worst is to fund early payouts. Value-creating strategies are more acceptable than artificial boosts to the fund’s returns.
Conclusion
Though NAV lending remains a debated topic, it is gaining wider acceptance, especially during economic downturns and periods of tight capital. As the market for capital grows and offers more options, it’s crucial for GPs and LPs to stay aligned for NAV loans to be adopted over the long term.
LPs (Limited Partners) are more supportive of NAV loans being used for growth rather than early payouts for several key reasons:
Long-Term Value Creation: When NAV loans are used for growth—such as funding new investments or expanding portfolio companies—there is potential for the overall value of the fund to increase. This can lead to larger returns in the future, which aligns with LPs’ long-term investment goals. LPs prefer strategies that enhance the value of their investment rather than short-term financial maneuvers.
Sustainable Fund Performance: Growth-oriented uses of NAV loans, such as making add-on investments or refinancing, help strengthen the underlying portfolio and increase the chances of future successful exits. This leads to more organic and sustainable fund performance, as opposed to short-term financial engineering.
Avoiding Artificially Inflated Returns: When NAV loans are used to fund early payouts (distributions), it can artificially inflate the fund’s internal rate of return (IRR), creating a misleading picture of the fund’s performance. LPs are wary of this because it can distort the true financial health of the fund. They prefer that returns be based on real profits rather than borrowed funds used to pay out distributions prematurely.
Lower Risk: Growth investments are seen as a way to build the future value of the fund, whereas early distributions can increase the risk if the fund hasn’t yet realized its gains. LPs are generally more risk-averse and prefer that the capital be used to strengthen the fund rather than being distributed early, which might compromise future returns.
In short, LPs favour the use of NAV loans for growth because it aligns with their long-term interests, leads to more sustainable performance, and avoids the risks associated with artificially inflating short-term returns.