Structural drivers of a fast-growing asset class

Q: The NAV finance market is now estimated at $100 billion. What is driving increased market adoption and does it differ between NAV loans to funds and GP- or LP level financing?

Fokke Lucas: We have a pretty unique view having essentially created NAV financing nearly two decades ago. We have seen increased demand year-on-year throughout that time and continue to see large and growing underlying locked-up NAV in buyouts. There is nearly $4 trillion of unrealised value in buyout funds in our space, which is Europe and the US, and that has doubled since 2019, thus doubling our addressable market.

Further, we see the adoption of NAV financing increasing with market liquidity remaining quite benign. Holding periods are stretching and that creates more financing needs for both managers that have already used NAV financing and those looking to explore it for the first time. About half our investments are with repeat clients, which means the other half is with managers using either a GP solution or a NAV facility for the first time. The majority of funds we work with are recognisable mid- to large cap buyout managers.

We see a few themes at present. First, when it comes to NAV loans to buyout funds, a lack of liquidity at asset level means managers are holding for longer. They continue to invest in M&A, but at some point they run out of capital, which is where NAV finance comes in.

Second, on the GP lending side, we work with both listed and non-listed groups using financing as a management company balance sheet optimisation tool. We see managers putting more capital into their own funds, looking to do significantly larger GP commitments than market standard. The current illiquidity of existing GP commitments and carried interest is driving the adoption rate.

The common thread we see is borrowers looking for flexible, well-structured transactions, certainty of execution and a cost of capital that is lower than the return of the opportunity they are financing.

Dane Graham: When it comes to LP-level financing, we see there is a growing awareness of the tools investors can use to manage their private asset portfolios. When LPs have selected good managers and like the assets, they want to hold onto them and allocate more regularly through different vintages. That is driving a desire to explore solutions like NAV financing that enable them to manage their book more holistically to achieve better outcomes.

Q: How is the current economic backdrop – higher-for-longer rates, a slower exit environment, muted distributions – shaping demand across the different borrower types?

"The overarching theme we see is that NAV is filling a structural gap, not a cyclical one."
Dane Graham

‍DG: Demand is not driven by this market environment but by growing adoption, though the current backdrop does mean GPs have to work harder on their portfolios and are looking for new tools to support them with that.

The driver is a structural gap that impacts each borrowing group slightly differently. At the fund level, a market example would be a fund that is fully invested and has an opportunity to do add-on M&A in a portfolio company but does not have enough available capital to execute on that. NAV financing can be a way to capture that value accretion.

From our experience, GPs seeing less liquidity in terms of carry because of longer hold periods need capital to deploy into GP commitments. The structural dynamic is that GP balance sheets need to grow and, as they launch new products and vehicles, GPs need to provide commitments to them.

Continuation vehicles also typically require GPs to roll their carry and GP commitment, putting further demand on the balance sheet. When you add generational transfers taking place, there are a lot of things driving that structural demand for GP financing.

Finally, we see that LPs have seen less liquidity over recent years but continue to want to make commitments that are often above and beyond what they have capacity for.. NAV allows them to do that without pulling back.

Q: How has the universe of lenders evolved in recent years? Has increased competition impacted pricing and terms?

‍DG: The size of the NAV financing market can support multiple providers. We see new lenders as continued validation of the asset class our firm originally conceived almost 20 years ago.

We see new entrants are either repurposing existing capital or operating at smaller scale – there remain few players with dedicated discretionary capital available to do the larger, $250 million-plus deals.

For borrowers that may have done hundreds of corporate-level or portfolio-level financings, NAV finance is new and tends to be strategic. That means they are focused on working with parties that have expertise gained across multiple transactions. They want lenders that can move with speed, scale and certainty.

Q: How do NAV loans from specialist lenders, such as 17Capital, differ from bank-led NAV loans?

‍Emad Shahin: Banks are incredibly important sources of capital for the financial system. To achieve scale they have to ensure compliance with both internal and regulatory requirements. They therefore approach NAV in that context: they offer a product that meets their requirements rather than those of sponsors. So they have pricing power, rather than flexibility.

Specialist providers, on the other hand, see what works for sponsors and investors and then shape a solution. They are typically much more flexible and experienced, tailoring elements like security requirements, the structure of the facility, the cash sweeps and the tenor as required.

The other big difference is focus areas. We are looking across the full spectrum of the NAV finance ecosystem at both the fund level and the managers themselves, both GPs and LPs. Banks tend to focus on one of those areas, predominantly on the NAV loan side, and they do not operate across the whole market. They follow their sponsor relationships rather than looking across the breadth of the offering.

Q: What are the key considerations when assessing a portfolio today? How do you get comfortable with valuations?

FL: The way we control risk for our investors is simple: it starts with the manager, then the portfolio and finally the structure.

We largely work with reputable, institutionalised managers. The average AUM of the 35 GPs we have invested with over the last five years is $85 billion.

We spend a lot of time looking at portfolios, understanding valuations and quality, and the institutionalised managers we work with have rigid valuation processes in place. We diligence those business models, valuation and capital structures, if we are not happy, we walk away.

After that, we look at the structure and how much capital we are willing to lend against the value of the portfolio. There are lots of tools that we can structure with but only if the fundamentals of the manager and the portfolio work.

Q: ILPA released guidance on NAV facilities in 2024. Has that had an impact on how deals are structured and disclosed?

ES: The ILPA guidance has been a fantastic catalyst for raising awareness across the industry. The focus was to facilitate disclosure, increase transparency and start discussions between sponsors and investors. Those things were already happening but the guidance triggered more conversations and we saw LPs calling sponsors asking them questions, rather than just being reactive.

Increased transparency and education has been a real impetus for adoption. The more that LPs know about NAV loans, the rationale for their use and the way they are structured, the more comfortable they tend to get with them.

Q: “Leverage on leverage” is a concern for investors. What impact do NAV loanshave on the total leverage in the system?

ES: Leverage in the system is generally a big focus for all parties, right from the portfolio company level upwards. We do not see NAV loans adding leverage, rather they transfer it within the structure to somewhere that is less risky and more efficient for the capital structure. It is just changing where leverage sits.

The big misconception is that it adds financial pressure to portfolio companies. In fact, it sits above them, so it does not add any operating burden to them. We actually see sponsors using NAV loans to clean up capital position sat portfolio company level, giving portfolio companies more runway without them having to worry about interest coverage ratios or impending debt walls.

Q: Regulators are turning their attention to private credit as a possible systemic risk. Is NAV finance exposed to the same vulnerabilities as other strategies, such as direct lending?

DG: Overall, there is recognition that the private credit landscape is broad and filled with multiple asset classes that have their own risk-return characteristics and dynamics.

The benefits of NAV financing are that you are well aligned with large, institutional GPs, managing performing portfolios that are also well aligned with their LPs. There is more alignment in structures than in other type of lending. But perhaps the biggest differentiator is there is no single company risk and no binary outcome within NAV financing. In direct lending, if a portfolio company defaults you are immediately thinking about recovery ratios and capital loss. With NAV, you get the benefit of an entire portfolio so performing companies can offset any non-performance issues.

Q: Where do you see the NAV finance market five or 10 years from now?

FL: We are just scratching the surface. If there is $4 trillion of locked up NAV in buyouts and we see around $60 billion of deal flow in our part of the market per year, we are only transacting about 1.5 percent of the market. As more investors, LPs and GPs understand the use cases, we are certain adoption will continue to grow.

We estimate the market will reach about $150 billion by 2030, and even then there may still be more room for growth. Similar to other liquidity tools – be it secondaries, capital call lines or continuation vehicles – NAV is fast becoming a standard portfolio management tool. We are convinced that what we offer will follow a similar path and end up at the forefront of investor minds as they think about managing portfolios.