NAV Loans: Double Edged SwordMarkdale
One of the main problems with private equity (“PE”) is the lack of liquidity. To get around this, companies often use so-called NAV loans. With the downturn in the mergers and acquisitions market during 2023, many PE investors are finding themselves in a tight spot, contemplating an expensive solution: borrowing against their stakes using net-asset-value (NAV) financing.
A Glimpse into the Appeal of NAV Loans
Lenders make NAV loans against PE holdings as collateral. The allure of net-asset-value funding is primarily their ability to unlock cash without necessitating the sale of private equity investments in an unfavorable market. In theory, these loans enable investors to secure immediate liquidity, which can then be channeled towards new ventures or to rebalance skewed allocations in their private equity portfolio. Some NAV loans may have margin triggers based on the value of the underlying asset. Other NAV loans may give the lender recourse against a larger portfolio of assets that is used to secure the loan.
NAV Loans: Pros and Cons
However, NAV loan financing is risky. The inherent costs, which can include high interest rates, can weigh heavily on the borrower. Coupled with the potential devaluation of leveraged private equity assets, this could pose substantial layered risks that don’t show up on everyone’s balance sheet.
Therefore, many investors are also treading with caution. There’s a prevailing hope for a resurgence in the asset sales market, which could pave the way for increased PE liquidity.
Diversification: A Potential Safety Net?
A notable aspect of NAV loans is the promise of diversification. Unlike traditional funds, which maintain a specific loan-to-value ratio, diversified portfolios can accommodate a broader loan-to-value spectrum due to the varied nature of their assets. So, borrowing against a single PE holding might not add much risk to a broader portfolio if its structured with specific terms shielding the larger pool of assets under management.
NAV Loan or Margin Loan?
Many investors who are considering funding their PE portfolio with loans should also consider alternative funding sources such as margin loans and other secured debt. Margin loans against liquid public securities are much cheaper than NAV loans. Furthermore, re-refinancing certain hard assets such as real estate may provide investors with better sources of liquidity. Most family offices should work with private bankers because they often can access so-called universal lending, where they create pools of assets as collateral for loans with terms much more flexible than NAV loans.
Potential Impediments to Returns
While NAV loans may appear as a beacon for those seeking swift liquidity, the repercussions are hard to ignore. Elevated interest rates can curtail overall returns, especially when the primary use of incoming distributions is to service the loan.
Furthermore, for smaller investors such as family offices with only a few private equity fund investments, the intricacies and inherent risks of lending against current equity values can be overwhelming. The absence of a comprehensive framework to assess these offers poses challenges, especially when seeking approvals. A potential economic downturn further muddies the waters, intensifying liquidity woes and amplifying the risk of loan defaults.
NAV loans present a tempting solution for those navigating the complexities of private equity. However, they’re not without their pitfalls. As the landscape of private equity continues to evolve, the onus is on investors to stay nimble and make decisions rooted in long-term objectives and a clear understanding of associated risks. Whether NAV loans solidify their position in the market or fade away remains to be seen.