NAV Facilities: The Institutional Limited Partners Association’s New Guidance

Executive Summary

Net asset value (“NAV”) facilities are credit arrangements underwritten by the value of a fund’s investment portfolio, in contrast to subscription credit facilities (“SCFs”), which are underwritten based upon undrawn commitments of a fund’s investors.  Although historically utilized in secondaries, private credit, and infrastructure, NAV facilities have gained traction in private equity (“PE”), with the market projected to expand from $100 billion of principal amount of facilities to $600 billion by 2030.  The Institutional Limited Partners Association (“ILPA”) recognized the growing NAV facility market in its recent release on guidance for NAV facilities for PE funds (the “ILPA Guidance”), noting that “NAV-based facilities can be a useful tool for capital structuring or to provide financing to support assets” while cautioning that their use “presents concerns for limited partners.”

Given that the NAV facility market is still maturing, particularly with respect to buyout funds, it is an appropriate time to identify potential issues in the market and advocate for solutions to such issues so that all market participants have a common set of expectations.  The recent ILPA Guidance does both, but some of the proposed approaches to address potential limited partners’ (“LPs”) concerns may not adequately reflect the traditional discretion of general partners (“GPs”) to manage funds and the unique nature of the NAV facilities market. 

NAV facilities enable GPs to provide interim liquidity, manage indebtedness, and support portfolio companies without liquidating assets, offering a potentially more cost-effective alternative to debt at the level of the investment or portfolio company.  GPs have to balance these benefits against the potential concerns that can be presented by NAV facilities, including transparency with respect to the use of such facilities by funds.

Limited Partner Concerns Regarding NAV Facilities

ILPA’s Guidance identifies several key LP concerns related to the use of NAV facilities by funds:

1. Transparency: The ILPA Guidance suggests that many LPs have limited visibility into the use of NAV facilities, and some LPs may only discover their existence through distribution notices or financial reports if there is not proactive disclosure by the GP.  When NAV facilities are used to support portfolio companies, a lack of engagement with LPs may lead LPs to believe the facility was obtained due to the GP’s failure to properly manage reserve capital.
2. Governance: Limited Partnership Agreements (“LPAs”) typically provide the GP with broad authority to manage the partnership, including the incurrence of indebtedness which is commonly subject to express limitations.  The lack of transparency with LPs is exacerbated by older LPAs that do not explicitly address NAV facilities, leading to inconsistent practices among GPs.  Some GPs seek broad approval from the Limited Partner Advisory Committee (“LPAC”) despite the general authority provided under the LPA, whereas others rely on that general authority or interpret the LPA’s leverage limitations to not apply to special purpose vehicle (“SPV”) subsidiaries where the NAV indebtedness is typically incurred.
3. Impact on Performance Metrics: The use of NAV facilities can affect performance metrics such as a fund’s Internal Rate of Return (“IRR”) and Distributions to Paid-In Capital (“DPI”).  One concern to LPs is that early distributions generated by NAV facilities could artificially inflate these figures, potentially misleading them about the fund’s performance.
4. Recallable Distributions: Distributions to LPs made with the proceeds of NAV facilities are often recallable, which can disrupt LPs’ cash flow planning and create tax and accounting complexities.  Moreover, the interest expenses associated with these facilities can negatively impact LP returns, especially when these distributions are recallable.
5. Cross-Collateralization Risk: The use of NAV facilities to support portfolio companies introduces the risk that strong-performing portfolio companies can be impacted in an event of default, particularly when proceeds are used to shore up struggling assets.  This can compromise better-performing assets and the differentiated returns LPs expect from private equity investments.

ILPA’s Recommendations for Improved Transparency and Engagement

Transparency Recommendations

To address these concerns and enhance transparency, ILPA recommends that GPs consider the following practices:

1. Engagement with LPAC: If the GP has not obtained the LPs’ consent for a NAV facility through express language in the LPA or otherwise, ILPA recommends that the GP seek consent from the LPAC before implementing a NAV facility regardless of the use of proceeds.  However, they also note that if facilities are to be used to generate distributions, LPAC approval should also be considered even if the LPA expressly permits the GP to have a NAV Facility.  This includes disclosing the rationale, size, structure, use of proceeds, and key economic terms of the facility, such as repayment requirements, cost of capital, and performance requirements.
2. Enhanced Disclosure Requirements: ILPA advocates for comprehensive disclosures to all LPs regarding the use of NAV facilities. Such disclosure includes providing detailed information on the facility’s rationale, structure, interest rates, covenants, and any potential conflicts of interest periodically.  GPs should clarify to LPs whether they interpret the LPA’s leverage limitations to apply to facilities at levels below the fund, such as any SPV and holding companies that may hold the fund’s portfolio investments. 
3. Proactive Legal Documentation: ILPA encourages the inclusion of specific language in LPAs for new funds that specifically relates to the use of NAV facilities. These provisions should include clear definitions, address applicability of leverage limits to NAV facilities, and describe reporting obligations to ensure that LPs are fully aware of the fund’s exposure to NAV debt.
4. Avoiding Broad GP Authority: ILPA advises against LPA provisions that grant GPs broad authority to implement NAV facilities with minimal LPAC or LP oversight. Such provisions should be narrowly tailored to ensure that GPs engage LPs appropriately when considering these facilities.

Proposed Legal Documentation

For LPAs that do not currently address NAV facilities, ILPA provides sample LPA provisions that explicitly define NAV facilities, provide express limits on the amount of leverage a fund can incur, and require GPs to obtain LP or LPAC consent before implementing such facilities regardless of whether the LPA expressly addresses them.  Such provisions may not be required from a corporate governance standpoint in order to enter into a NAV facility as they may be within the GP’s powers already provided for in the LPA.  However, they can clarify the permissible use of NAV facilities and establish appropriate guardrails.

Recommended Disclosures

ILPA’s guidance also outlines specific disclosure requirements that GPs should provide to LPs once a NAV facility is in place.  These disclosures should cover key details such as the size and structure of the facility, interest rates, covenants, the fund’s rationale for the indebtedness and plan for repayment, and any conflicts of interest.  ILPA emphasizes the importance of transparency in helping LPs assess the risks and potential impacts of these facilities on their investments.

NAV Facilities in Context

General Partner Authority to Borrow

LPAs generally authorize GPs to take all actions on behalf of the fund and typically expressly provide the GP with authority to borrow, pledge assets and to use proceeds of such borrowings for the benefit of the fund.  Such authorization is not generally conditioned on obtaining LPAC approval or express reporting requirements on the business terms of such borrowings.  Given that NAV facilities are not inherently different than other forms of debt that may be taken on by a fund, ILPA’s proposed LPA provisions requiring LPAC approval and disclosure of business terms in connection with such approval seem inconsistent with the traditional discretion afforded GPs. 

Contrasting NAV Facilities with Subscription Credit Facilities

While debt is debt (as suggested above), what distinguishes NAV facilities (and other fund borrowings) from SCFs is the SCF lenders’ reliance on market LPA provisions because the type of collateral involved in an SCF is created by virtue of the LPA itself.  SCF lenders look for specific language in LPAs that supports a lender’s collateral package relating to capital commitments, often including specific waiver of defense language relating to capital contributions and other provisions that bolster a lender’s reliance argument in the unlikely event that such lender calls on LPs to make capital contributions to a fund in an enforcement scenario.  Lenders in NAV facilities don’t have the same issues.  Simply put, lenders in NAV facilities don’t have collateral that is created by the LPA, need to have waivers to defenses to funding their collateral, nor do they need to establish a reliance argument to support their rights to enforce on the collateral pledged by the borrower to secure a NAV facility.  Accordingly, market participants might reasonably expect LPA provisions related to NAV facilities would be more in line with the traditional discretionary authority of a GP to borrow, or general limitations on fund level debt, which may not specifically mention a NAV facility, rather than the type of express and more extensive provisions included to support a subscription credit facility.

Recallable Distributions

The ILPA Guidance identifies the risk of recallable distributions as a material concern of NAV facilities.  LPs may generally face a risk that distributions (or some portion thereof) are recallable.  While NAV facilities can be utilized to make distributions, LPs generally develop strategies to manage the risk of recallable distributions.  Additionally, the use of proceeds of SCF’s can also often be used to make distributions as well. 

Market Controls

The ILPA Guidance notes that NAV facilities can impact performance metrics, in addition to increasing the risk of recallable distributions and creating a lack of transparency, but it seems that the misuse of NAV facilities to achieve an artificial short-term metric would be addressed by one of the concepts that has been credited with keeping the SCF market so stable – repeat players.  In many instances, the market participants in the NAV facility market are the same as those in the SCF market and sponsors and LPs are expected to be repeat players over time.  If a GP uses NAV facilities in a manner that negatively impacts LPs in its funds, it would be expected to pay a price in the future for such action, whether resulting from a lack of transparency, introducing volatility that required recalling distributions, or temporarily inflating IRR and DPI metrics.  Market controls have been a stabilizing influence on the SCF market and they may well act in the same way in the NAV facility market, which would soften the need for restrictive provisions in LPAs.

Takeaways

The ILPA Guidance on NAV facilities laudably calls to promote transparency and dialogue between GPs and LPs with respect to the use of NAV facilities by PE funds.  By following ILPA’s recommendations, GPs may foster stronger relationships with their LPs and mitigate the risks associated with NAV financing.  At the same time, acknowledging that NAV facilities are different from subscription credit facilities and that other market controls exist to limit the use of NAV facilities, market participants may look to rely on more traditional GP discretion powers in constituent documents.  What is clear is that NAV facilities have become more common and can be a useful tool for capital structuring and supporting assets of a fund.  Funds and GPs that want to make the best use of this growing market should be aware of and sensitive to the concerns of their LPs.