We refer to the ILPA (Institutional Limited Partners Association) guidance note entitled NAV-Based Facilities – Guidance for Limited Partners and General Partners published on 25 July 2024 (the Guidance). We are issuing this client alert in response to the Guidance and information set out within the Guidance with the purpose of providing the Reed Smith perspective on the use of NAV facilities. While we are encouraged by the work that ILPA has done preparing the Guidance, we wish to clarify a number of the statements that ILPA has made in the Guidance and which are highlighted in red below, together with the Reed Smith response. Our general position continues to be that NAV facilities are a useful tool that permits GPs to manage the cashflows and timing issues associated with operating private equity funds.
ILPA Statement: “The collateral used in NAV-based facilities is generally cash received in the bank accounts of the borrowing entity, i.e., the fund or a fund subsidiary, together with a preferred equity interest in the fund’s income and distributions from the fund investments.”
Reed Smith Response: We agree that in most NAV facilities to PE funds there will be bank account collateral provided over the account into which distributions from underlying investments are paid. However, in our experience, it is not usual for the NAV lenders to have any sort of preferred equity interest in the fund’s income. A NAV lender will generally have a prior claim on any distributions that come up from the portfolio on an insolvency or bankruptcy as the NAV lender will be a creditor of the borrower rather than the investors who are equity holders, but there are a limited number of instances where we have seen preferred equity interests issued to lenders. Unless there is an LTV breach or other default, it is not usual for the NAV lender to receive a full cash sweep of distributions ahead of the investors. Depending on the strength of the sponsor and change of control restrictions in shareholders’ agreements in the equity structure, there may also be a pledge of, or security over, the equity interests in some or all of the portfolio.
ILPA Statement: “NAV-based facilities often involve creating two special purpose vehicles, or SPVs. The first SPV is created to incur the financing under the NAV facility and hold the equity interest of the second SPV (Holdco), which aggregates the underlying fund interests in the borrowing base”
Reed Smith Response: This would be an ideal situation for a NAV lender that was providing a limited recourse NAV facility to a PE fund to ensure that there was no recourse to the fund or need for the fund to sign anything in connection with the transaction. However, in many instances the PE fund has not been set up with this double Holdco structure and the fund may be reluctant to restructure the existing equity structure to accommodate a NAV facility. We have seen deals with a single umbrella Holdco borrower under the fund or a newly created finco entity that borrows the debt and on-lends into the equity structure, or indeed the fund itself borrowing the debt if this is permitted under the LPA. The structure of each NAV transaction needs to be looked at on a case-by-case basis and so it is dangerous to generalise as to what a financing structure will often look like.
ILPA Statement: “It is ILPA’s position that NAV-based facilities constitute fund-level leverage and, as such, should be included in borrowing limitations.”
Reed Smith Response: We believe that whether NAV based facilities constitute fund-level leverage should depend on the drafting of the LPA and the extent to which it is clear that NAV facilities are not caught by the fund-level borrowing limitations. Clearly if the LPA expressly states that NAV facilities are not included within the fund borrowing limitation this statement should be conclusive.
ILPA Statement: “The use of NAV based facilities to generate early distributions presents challenges for LPs, given the impact on IRR/DPI, interest expense associated with these vehicles, and the fact that such distributions are often recallable”
Reed Smith Response: ILPA seems to be overly focused on the used of NAV facilities for distributions and how this may cause a negative impact on investors. We are aware of some PE fund managers that are very lowly levered at the portfolio level and may have acquired a number of their assets in whole or through drawdowns from investors. This is often the case for emerging markets funds where the cost of borrowing at the portfolio level does not merit the incurrence of local level debt by the portfolio companies. A NAV based facility may provide the leverage that these funds need if they are lowly levered and furthermore for these funds provide a more cost efficient form of financing. The diversity of the collateral may allow a NAV lender to provide lower cost financing to fund than incurring debt on an investment by investment basis. A NAV facility of this nature and rationale will result in a distribution to investors, which distribution may well be recallable – but none of that is negative for the investors.
ILPA Statement: “At the outset, funds should have significant and sufficient reserve capital to support portfolio companies after the end of the investment period, to fund potential follow-on investments or opportunistic investments, or to support portfolio companies in challenging market environments.”
Reed Smith Response: We view ILPA’s position here as too idealistic. Recent global events have shown that it is difficult to fully predict what the right level of sufficient reserve capital should be to support portfolio companies. We saw NAV facilities play a very important role during the Covid pandemic. A completely unforeseen event, the pandemic left a number of PE funds with investments that were very short on cashflow. Our law firm worked on a large number of NAV facilities that played a key role in supporting the portfolio for a limited amount of time until the economic impact of the covid pandemic had stabilized. Without these NAV facilities, more portfolio companies could have become insolvent with the negative impact that would have on employees, investors, and other stakeholders.
ILPA Statement: “Assuming that the GP has received prior consent to use a NAV facility (whether in the LPA or through prior LPAC approval), GPs should not be required to return to the LPAC for consent to use a NAV facility to support the portfolio. In these cases, this facility should be treated like more traditional leverage. LPs expect that it is the responsibility of the GP to manage the risks and expenses associated with leverage in the fund, and to comply with any fund-level leverage restrictions in the LPA”
Reed Smith Response: We thoroughly support this statement by ILPA in the sense that it is the responsibility of the GP to manage the risks and expenses associated with leverage in the fund. Investors into PE funds do not ask for specific disclosure or to monitor on a case-by-case basis the terms of leverage that a fund manager takes out for each of its separate investments so why should there be additional LPA consent needed with respect to NAV facilities? If the concern of investors is that the GP should not be permitted to take out NAV facilities that are cross collateralized between different assets without specific investor consent, then this should be provided for in the LPA upfront as a specific LPAC consent item. But if investors are happy to leave the GP to make such decisions as and when (and if) the GP feels the time is right, there is no benefit in having LPAC consent required as well. We return to our example of some of the emerging market funds that have NAV facilities and who on an aggregate basis may be more lowly levered than other PE funds that do not have NAV facilities in place. GPs should be given discretion to manage how they operate the fund with respect to leverage, within the parameters of the LPA.
ILPA Statement: “New LPAs should set shared expectations around how NAV-based facilities are reported. For example, the ILPA Model LPA requires
15.2.1 Until the final liquidation of the Fund, the General Partner shall cause the Fund to prepare and provide to each Limited Partner the following:
15.2.2.8 the amount of debt for which the Fund generally, and any Portfolio Investment particularly, is directly or indirectly encumbered, as well as whether or not any such debt is recourse to the Fund or to a Portfolio Company or is cross collateralized among other investments or vehicles managed by any Interested Person.
15.2.3.5 a report of the total debt and credit in use by the Fund, including with respect to any Credit Facility: (a) the balance and percentage of total uncalled capital; (b) the number of days outstanding of each Drawdown; (c) the current use of proceeds from each facility; (d) the net internal rate of return with and without the use of the Credit Facility; (e) the terms of the Credit Facility (including but not limited to any upfront fees as well as drawn and undrawn fees); (f) costs to the fund (including but not limited to interest and fees); and (g) any such further information the GP shall deem appropriate.”
Reed Smith Response: This is a significant amount of disclosure with respect to the specific operating terms of the NAV facility. Furthermore, there is no mention of how regularly this information needs to be provided to LPs. If this is on an annual basis it may be workable for the GPs, but if this is on a quarterly basis we would predict a large additional amount of administration for the operations teams at fund managers. It seems more reasonable to disclose the general terms of the financing at the outset, if this is required by LPs or needs LP consent, rather than regular disclosures during the life of the facility itself.
ILPA Statement: “Additionally, borrowing provisions within new LPAs should include concepts that encapsulate NAV-based facilities, so that LPs are informed as to the amount of leverage a fund is able to incur through traditional fund-level leverage as well as through NAV-based facilities. For example:
The fund may incur indebtedness for borrowed money (including by way of entry into a subscription facility or a NAV-based facility) provided (i) that any Subscription Facility borrowing shall be on a short-term basis for periods of less than [six months] to finance investments pending receipt by the Fund of Drawdowns, (ii) that any borrowing from the General Partner, the Fund Manager or their respective Affiliates shall (A) contain terms that are no less favorable to the Fund than could be obtained in arm’s-length negotiations with unrelated third Persons for similar borrowings and (B) in the case of a NAV-based facility, require the prior written consent of the Advisory Committee, and (iii) that, at any time, the aggregate liability of the Fund with respect to all such borrowing, guarantees and indebtedness (including, without limitation, pursuant to a NAV-based facility) does not exceed [X]% of the total Commitments..
Reed Smith Response: The proposed ILPA language with respect to NAV facilities in LPAs requires consent of the Advisory Committee for any NAV facility. We suggest that investors and GPs be given the freedom to expressly permit upfront the ability of the GP to take out a NAV facility should they wish and so agree. Investors would be free to apply certain conditions to the terms of such NAV facilities upfront to avoid delays and uncertainties for GPs getting Advisory Committee consent later in the life of the fund when GPs consider it the right time to take out a NAV facility.
ILPA Statement: ILPA recommends that GPs provide all LPs within the fund with the following standardized disclosures about NAV-based facilities once they have been put in place.
Reed Smith Response: ILPA has laid out specific questions that GPs should answer once NAV facilities are put in place, so that the investors understand the basic terms and risks of any NAV facility that has been taken out. We agree that it is helpful to provide key disclosures on the NAV facility to investors once put in place, but we would suggest that one key item is missing from ILPA’s suggested list. We would add the following question
“Are there any change of control provisions in any shareholders agreements or regulatory or other required consents, that could be triggered by any lender action on default under the NAV facility?”
We provide our responses and views based on the large number of NAV facilities we have worked on in our fund finance team over the past 10 years, but we very much welcome your views on our perspective.
