ILPA releases new NAV facilities guidance: Considerations for limited partners, general partners, and lenders

The Institutional Limited Partners Association (ILPA) recently released new guidance on net asset value (NAV) facilities for limited partners and general partners.

NAV facilities – which are credit facilities secured by the value of a fund’s investments – are increasingly used by sponsors to manage debt, liquidity, and support fund assets.

As evidenced by increasing headlines and workflow, we continue to see the evolution of the fund finance marketplace and the NAV loan product in particular.

While driven by many factors – fundraising challenges, need for liquidity to drive distributions to paid in capital (DPI), support for existing portfolio companies or for new investments, or other bespoke considerations – it is fair to say that industry participants are encouraged to engage more meaningfully on the NAV topics in order to ensure a more complete understanding of the usage and risks of these facilities, both in terms of their relationships and investment portfolios.

We would expect the key recommendations provided in the much-anticipated ILPA guidance to be the basis of material conversations among industry participants if not adopted in some form by certain institutional investors as part of their underwriting and portfolio management processes.

ILPA’s guidance provides a thorough overview of the history and current use developments of NAV financing in private equity strategies. It also outlines significant concerns of limited partners related to use of NAV facilities and provides recommendations to address those concerns.

Below, we outline how those recommendations relate to the most pressing concerns for limited partners, note the high-level recommendations for limited partners, provide key takeaways for sponsors to prepare for and address these concerns among their investor bases, and set forth considerations for lenders given the new guidance.

Key concerns of limited partners

The ILPA guidance identifies the below issues as key concerns for limited partners related to NAV-based financing:

• Limited insight: Limited partners often are not aware of when and how NAV-based facilities are being used by their private fund sponsors. Given the recent headlines around these facilities, limited partners are receiving more questions from their stakeholders on the exposure, use, and type of NAV facilities in existing portfolios.
  
  
• Lack of governance: In addition to limited (if any) disclosure, limited partners rarely have any consent rights related to use of NAV facilities.
  
  
• Lack of consistency: Where the governing documents are silent on use of NAV-based debt, general partners have taken different approaches to how they treat NAV facilities. Some general partners have interpreted traditional fund-level leverage provisions in limited partnership agreements as providing sufficient authority for them to utilize NAV facilities without limited partner notification or engagement, while others use special purpose vehicles and other intermediate structures to effectively avoid fund-level leverage limitations.
  
  
• Increase in use: The market has seen an increased use of these facilities during the more challenged fundraising environment. This creates more risk to manage across the investor portfolio. The lackluster macro mergers and acquisitions climate of recent years and the resulting extended hold period for investments have also led sponsors to increasingly utilize these facilities.
  
  
• Use of proceeds: ILPA highlights particular concern with the use of NAV facilities for the purpose of making early distributions to limited partners (sometimes known as DPI management). ILPA guidance reflects that this practice is expensive for and disruptive to limited partners’ ability to allocate capital – considering such distributions are often recallable – and creates conflicts between general partners and limited partners around improving IRR and DPI performance figures and related matters. However, limited partners are generally supportive of the use of NAV facilities for follow-on investments or new investments.

Key recommendations for limited partners

To address the concerns above, ILPA recommends that limited partners negotiate for the following:

• LPAC consent required: Unless otherwise expressly permitted by the governing documents of a private equity vehicle, ILPA recommends that general partners seek LPAC consent to implement a NAV facility or otherwise utilize NAV-based debt at the fund level (or through a structured subsidiary that effectively leverages a significant portion or the entire fund portfolio).
  
  
• LPAC review of conflicts of interest: ILPA recommends that any conflicts of interest associated with a NAV facility be brought to the LPAC.
  
  
• Separate approval required for distributions: ILPA recommends that the LPAC should provide express approval before the general partner may use proceeds to generate a distribution.
  
  
• No separate approval required for portfolio support: ILPA advises that once a facility is approved, general partners should be permitted to use a NAV facility to support the Fund’s portfolio without the need to return to limited partners or the LPAC for consent.
  
  
• Standardized disclosure: The ILPA guidance recommends specific standardized disclosures about NAV facilities once they have been put in place, including material terms such as rationale, size, amounts borrowed, LTV at initial date of borrowing, interest rate, and term.

What does this mean for sponsors?

General partners may expect an increase in limited partner requests – during initial diligence, in fundraising negotiations, and in portfolio monitoring – with the aim of addressing NAV financing in the fund’s governing documents and through regular fund reporting. To be adequately prepared these concerns, sponsors may consider the following:

• Audit current forms and reporting: Sponsors may review their current standard fund forms and reporting to analyze current disclosure and consent requirements related to NAV facilities. Prudent sponsors will be proactive in their conversations with their investors.
  
  
• Compare standard reporting to ILPA recommended disclosures: Sponsors are encouraged to be prepared to answer investor questions on the extent to which existing or future borrowings will satisfy (or not satisfy) ILPA’s recommend disclosure related to the use of NAV facilities.
  
  
• Review and prepare for ILPA suggested diligence: ILPA has provided a list of nine suggested diligence questions to guide limited partners in discussions and negotiations with general partners regarding NAV financing. Sponsors may review the recommended questions closely to anticipate and prepare responses and/or revisions to standard documents or reporting to mitigate limited partner concerns and requests related to this issue.

What does this mean for NAV lenders?

Bank and non-bank lenders in the private markets space are expected to be generally supportive of ILPA’s recommendations for increased disclosure to limited partners on the uses and terms of NAV facilities.

From the lender perspective, limited partner concerns about the use of NAVs for distributions may already be sufficiently addressed by current practice, as most lenders are reporting that NAV facilities are largely being used for the purpose of supporting portfolio investments.

Prudent NAV lenders will be cognizant of the ILPA guidance, as developing conversations between general partners and their investor bases may impact the risk associated with NAV lending.

Importantly, NAV lenders are encouraged to update their diligence process to include specific questions about limited partner consent rights or notice rights related to NAV facilities (whether provided for under the fund governing documents or in a side letter) and ensure these are sufficiently addressed as part of the conditions precedent to the NAV facility closing.

Lenders may also consider updating their offerings to future borrowers to take into account any further debt limits or approvals related to NAV financing.

Finally, NAV lenders may consider reviewing the ILPA recommended disclosure package to prepare for general partner requests to provide related terms for the general partner’s own disclosure needs.

An ongoing discussion

Similar to subscription facility financings, which were largely controversial as they gained popularity but are now a highly typical feature of private equity strategies, NAV financing can be utilized by private equity sponsors to the benefit of all parties and with the comfort of the investor base.

Ideally, the ILPA guidance will lead to more sophisticated and productive conversations between general partners and limited partners on how to achieve that goal, and a more active and liquid NAV loan market to support sponsors as part of their financial toolkit.

If you have any questions about the new ILPA guidance on NAV facilities, please do not hesitate to contact the authors or your DLA Piper relationship attorney.