Buyout firms have long relied on controversial loans backed by equity stakes to enhance fund returns, but growing investor criticism has triggered a slowdown, according to a report by Bloomberg UK.
Net-asset-value (NAV) loans, which layer additional leverage onto private companies already burdened with significant debt, have come under scrutiny, particularly when buyout firms use them to fund distributions rather than growth. Many firms borrowed against their portfolio companies to sustain the private market boom while dealmaking dwindled.
With even the recipients of those payouts raising concerns, efforts are underway to redirect the use of NAV loans. Ares Management, Perpetual Investors, and 17Capital report that NAV loans are increasingly being reinvested into portfolio companies or utilised for add-on acquisitions instead of being used for payouts.
This shift partly reflects a rebalancing of power, enabling LPs in private equity funds, such as pension funds to exert influence over GPs.
“Using NAV loans for distributions is somewhat like kicking the can down the road,” said Christian Wiehenkamp, Chief Investment Officer of Perpetual Investors. “LPs don’t seem to like that and since GPs are no longer calling the shots without respecting the nature of a longer partnership, GPs seem to have listened.”
While NAV loans have been around for over a decade, they became a lifeline for PE firms during a recent slowdown in deal activity, helping to generate cash that would ordinarily come from asset sales. Now estimated to total around $50bn, according to Ares, NAV loans have drawn warnings from regulators concerned about their potential risks to the broader financial system.
Reportedly according to the Rede Partners NAV Financing Market Report 2024, there is concern that these loans could weaken portfolio companies, and while they may boost returns initially, they could erode them over time.
“I’m sure there are some LPs who would have loved to get distributions through any means they could over the past couple of years,” said David Wilson, a Partner at 17Capital, a leading provider of NAV loans. “Other investors who are sitting on a lot of cash may see this as an expensive way to get cash back.”
Data on NAV loan usage remains sparse. Private equity financing methods and sources are among the most closely guarded secrets in this already opaque sector. However, current trends suggest firms are steering clear of transactions that have raised concerns.
“Money-out” transactions—where the sole use of proceeds is to distribute cash to limited partners for liquidity or performance purposes—accounted for just 3% of 2023’s volume, according to research by 17Capital, which includes deals done by competitors. This marks a sharp decline from 24% in 2022.
17Capital’s pipeline data suggests this figure will drop to 2% in 2024, though the firm notes that information for the period is incomplete. Investors in PE overwhelmingly support reinvesting cash raised through NAV loans, as shown in a survey by Rede Partners.
“It’s a trend that we’ve seen LPs support,” said Richard Sehayek, Managing Director in Alternative Credit at Ares. “Now there’s much more discussion with investors, more transparency and more education.”
Bryan Barreras, Counsel at Cadwalader, Wickersham & Taft, who represents NAV lenders, argues that the debt carries less risk than many assume, as loans are typically secured by collateral valued at three times their amount.
Nevertheless, the Institutional Limited Partners Association (ILPA), a trade body representing investors in private equity firms, has emphasised that private equity managers should notify investors before borrowing against their funds’ assets. The ILPA warns that any distributions received from a NAV-based facility might later be recalled to help repay the loan.
“The ILPA guidance focused quite a bit on the money-out transactions, even though it’s such a small part of what’s happening out there,” said Wilson at 17Capital. “The guidance was about making sure that NAV loans are being used properly rather than saying they shouldn’t be used at all.”
