The use of net-asset-value (NAV) loans by private equity firms to boost returns has come under increasing scrutiny from investors. After a period of heavy reliance on these controversial loans, particularly to fund distributions rather than growth, the industry is shifting gears. This article explores the evolving landscape of NAV loans in private equity and the growing influence of limited partners (LPs) in shaping their usage.
For years, buyout firms utilized NAV loans, which add leverage to already indebted companies, to enhance fund performance. This practice drew criticism, especially when used to finance payouts instead of investing in portfolio company growth. During a recent deal-making slowdown, many firms leaned heavily on these loans to maintain distributions to investors, keeping the private market seemingly buoyant.
However, this strategy raised concerns among LPs, who began to question the long-term implications of relying on debt to fuel distributions. Leading private equity firms like Ares Management Corp., Perpetual Investors, and 17Capital are now responding to this pressure by increasingly allocating NAV loan proceeds towards reinvestment in portfolio companies and add-on acquisitions, rather than payouts. This shift reflects a broader power dynamic change, where LPs are exerting greater influence over general partners (GPs).
“Using NAV loans for distributions is akin to delaying the inevitable,” explains Christian Wiehenkamp, Chief Investment Officer of Perpetual Investors. “LPs are generally averse to this approach, and as GPs recognize the importance of long-term partnerships, they are adapting their strategies accordingly.”
While NAV loans have been around for over a decade, their use surged during the recent deal drought, providing PE firms with an alternative source of cash typically generated from asset sales. Currently estimated at around $50 billion by Ares, these loans have attracted regulatory attention due to concerns about potential systemic risks.
The core issue is that NAV loans can weaken portfolio companies. While they might initially inflate returns, they can ultimately dilute them over time.
“Some LPs might have welcomed distributions by any means necessary during the past few years,” notes David Wilson, a partner at 17Capital, a major provider of NAV loans. “However, investors with ample cash reserves may view this as a costly way to receive returns.”
Comprehensive data on NAV loan usage remains scarce, reflecting the inherent opacity of the private equity industry. Nevertheless, emerging trends suggest a move away from the most controversial applications of these loans. According to 17Capital’s research, “money-out” transactions, where proceeds are solely used for LP distributions, constituted a mere 3% of 2023 volume, a sharp decline from 24% in 2022.
Preliminary data from 17Capital indicates this figure could be as low as 2% for 2024. Furthermore, a Rede Partners survey reveals that private equity investors overwhelmingly favor reinvesting NAV loan proceeds.
“We’ve observed strong LP support for this trend,” says Richard Sehayek, Managing Director in Alternative Credit at Ares. “There’s now significantly more dialogue, transparency, and education surrounding NAV loan usage with investors.”
Bryan Barreras, Counsel for Cadwalader, Wickersham & Taft, representing NAV lenders, argues that these loans are less risky than perceived due to collateral typically exceeding three times the loan value. However, the Institutional Limited Partners Association (ILPA) advocates for preemptive investor notification before firms borrow against fund assets, highlighting the risk of potential distribution recalls to service the debt.
“ILPA’s guidance heavily emphasized money-out transactions, despite their relatively small proportion,” states Wilson of 17Capital. “The focus was on ensuring responsible NAV loan utilization, not prohibiting their use entirely.”
In conclusion, the private equity industry is recalibrating its approach to NAV loans in response to investor scrutiny and a changing market landscape. The emphasis is shifting from using these loans for distributions to reinvesting in portfolio companies and pursuing strategic acquisitions. This evolution highlights the growing influence of LPs in demanding greater transparency and responsible financial practices within the private equity sector. While NAV loans remain a tool in the PE toolkit, their application is undergoing a significant transformation, prioritizing long-term value creation and alignment with investor interests.
