Demand for net asset value-based lending and preferred equity solutions has surged in the past 18 months, latterly spurred on by private equity funds' need for cash for portfolio companies in the face of the pandemic.

Both tools complement subscription lines, which are commonly used as the first lending mechanism in the life cycle of a fund.

As the name implies, NAV-based lending typically requires some fund investments. NAV facilities are usually set with a loan-to-value test, which is then calculated so it does not exceed a certain percentage of a fund's net assets, Thomas Liaudet, partner at placement agent Campbell Lutyens & Co. Inc. said.

"If your fund has $1 billion of assets in the ground and lenders say, look, we'll give you a 10% loan-to-value, you have to make sure that your fund doesn't decrease to below $1 billion because then you bridge that threshold in the LTV. This is tested periodically and if failed, the facility may have to be repaid or additional collateral provided by the borrower," Liaudet said.

Prior to the pandemic, lenders often drove conversations around NAV financing. There was "a lot of interest" from private equity firms, "but that's just what it typically was at that stage — interest," Jamie Mehmood, head of fund finance advisory at Deloitte, said. Discussion was largely around using the facility for "upstreaming," allowing funds to get distributions back to their investors sooner.

But following the initial lockdown, "we very much saw the pendulum swing, with managers increasingly being the ones to pick up the phone," Mehmood added. As managers sought liquidity to protect underlying assets, interest in NAV financings grew.

As the dust settled, managers saw opportunities for expansionary M&A, and NAV-based lending offered a tool to allow them to execute on such strategies without requiring additional equity. "That was very much the tone for the second half of 2020 and going into 2021," Mehmood said.

With plenty of competition for assets in winning industries following the outbreak, and managers keeping hold of assets in situations where they see the ability to create further value or want to avoid forced selling, "upstreaming" conversations are building once again.

"We very much feel that over the last 12 months the private equity market has accepted NAV financing as a proven way to raise flexible capital," Mehmood added.

Although NAV-based loans provide some flexibility to funds, preferred equity structures can offer even more to managers, advisers said.

Preferred equity, which is provided by specialists and some secondaries funds, provides capital to a vehicle, which typically ranks senior to limited partner interests and can be backed by the remaining fund portfolio as collateral.

These bespoke deals are typically structured through a priority claim to a portfolio's distributions, up to a certain multiple of capital invested, ranking generally between debt and ordinary equity, Liaudet said. Once the provider's minimum return is achieved, they may have a small slice of equity or an additional upside sharing agreement, which is intended to provide additional upside return.

Preferred equity is more costly, with providers looking for a minimum return on their capital, rather than repayments with interest as is required with NAV-based lending. It is also more flexible as it does not involve a stated maturity or repayment date, he added.

But such solutions offer "full flexibility of cash," Sunaina Sinha Haldea, managing partner of placement agent Cebile Capital LLP, said. "You can use the cash to pay out and buy out existing investors as a secondary, you can use preferred equity cash for buy and builds into your existing portfolio, you can use preferred equity to do new deals," Sinha Haldea explained. "Whereas NAV financings are debt, they come with covenants and restrictions on use. And typically, [NAV facilities] are not to be used for things like secondaries and for new deals."

Democratizing use

It is "best practice" to get limited partners and limited partner advisory committee approval before putting in place NAV financing or preferred equity regardless of whether the approval of one or both is included in a limited partnership agreement, Sinha Haldea said.

The payoff for all involved is the potential added value that such a mechanism provides. "You have to show LPs with or without the money, what does your return come to?" Sinha Haldea said. For the general partner, its carry is "worth a lot more" because they will have "created a more valuable portfolio."

The defensive and offensive dynamics that the outbreak of COVID-19 prompted for private equity portfolios have helped "democratize" preferred equity and NAV financings, Sinha Haldea said.

The pandemic in itself has not accelerated the use of NAV financing or preferred equity, Liaudet said, but there have been some factors that have spurred the use of such structures along.

Discussing the use of preferred equity historically in particular, when there is more volatility and a larger bid/ask spread from buyers and secondaries players, people begin to look at such structures, Liaudet explained. "We can't meet on pricing. Well, maybe we can find a way to make it work with the preferred equity structure. It's always been the case across the years. But as soon as the market comes back, people forget about the preferred equity discussions and they just go into a straight sell."

But an additional driver is demand. There is an increasing number of specialist providers or secondary funds offering NAV financing or preferred equity solutions in the market. Although independent of the pandemic — "it was already in motion" — an influx has coincided with an increase in demand: "more people doing it, more funds being raised, in particular in 2019 and 2020," Liaudet said. "When you have more capital seeking those opportunities, it stimulates the transactions as well."