In the last 18 months, as we have already mentioned here, here and here, the use by private equity funds of both NAV loans and private equity solutions has increased. For our purposes, NAV loans are loans to private equity funds that are backed, on a secured or unsecured basis, by the value of the assets of the private equity fund. Loans are senior obligations of the loan fund and are documented in loan agreements with strong statements, covenants and events of default. Loan covenants generally place limits on the activities of the loan fund, such as the amount of aggregate indebtedness it can incur, its ability to pledge or dispose of investments, and its use of cash received from financial institutions. portfolio investments. NAV loans have fixed maturities that can only be extended with the agreement of the lenders and have largely fixed returns to the lenders (usually in the form of a variable interest rate plus a spread).
Private equity solutions provide capital to a private equity fund through the issuance and sale of equity capital, or “preferred shares,” which preferred shares are not secured by the assets of the private equity fund. . Claims of preferred shareholders have priority over claims of investors in the issuing fund’s ordinary shares, but less than claims of creditors of the debt. Preferred shares generally place fewer restrictions on the activities of the issuing fund and do not have fixed maturities. They also offer more flexibility in structuring the return to the donor (that is to say, the buyer of the preferred shares), often giving the preferred shareholder a priority right to distributions from a fund’s investment portfolio up to a certain multiple of the purchase price of the preferred shares (the rate of return minimum). This threshold level, if reached, provides the purchaser of the preferred shares with a minimum rate of return on their investment before the right of common investors to receive further distributions of capital resumes. Even after the minimum rate of return has been reached, the preferred shareholder may retain an additional (but reduced) right to the residual value of the fund’s investment portfolio alongside ordinary investors.
NAV loans and preferred stocks provide capital that allows private equity funds to monetize or expand their investment portfolios, and we often come across both of these options in the context of a private equity fund determining the best way to raise capital for these purposes – that is to say, whether the fund prefers the lower cost of a loan or the flexibility of preferred stocks. Unsurprisingly, however, we are increasingly seeing NAV loans and preferred equity solutions deploying together, with investors in private equity funds (including secondary funds) using NAV loans to fund their operations. purchases of preferred shares.
Lending against preferred stocks rather than portfolio investments raises particular issues. We highlight some considerations for lenders for these types of installations below:
- Evaluation. Lenders should ensure that the valuation of the pledged preferred shares for the borrowing base and LTV calculations is appropriate for the distribution and liquidation rights attributable to the preferred shares in the constituting documents of the issuing fund. Additionally, since preferred stocks always rank behind any debt, lenders should ensure that any debt incurred by the issuing fund is factored into the production of these valuations.
- Cash flow. Once the minimum rate of return for the Preferred Shares is reached, the value of the Preferred Shares will be significantly reduced, even if a significant amount of value remains in the Portfolio. Lenders should structure cash transfers and loan amortization arrangements to ensure loan obligations are repaid before the minimum rate of return is reached.
- Passive investments. Preferred stocks are generally structured as passive investments with respect to the issuing fund and its underlying portfolio. Unlike a foreclosure on an investment portfolio under a NAV loan, lenders will not assume any active rights of management or disposition over the underlying investments upon foreclosure. Lenders should carefully check the constituting documents of the issuing fund to ensure that the distribution and liquidation rights of preferred stock holders are sufficiently hardwired.
- Due diligence and consent. Although preferred stocks provide economic exposure to an investment portfolio, this exposure is provided through securities issued by a single fund. The ability to seize lenders to effect a disposition of preferred shares pledged as collateral will depend on the terms of those preferred shares. To the extent possible, lenders should obtain the consent of the issuing fund both (i) the pledge of the preferred shares that are pledged to secure the loan obligations and (ii) the transfer of those preferred shares in the event of a default. foreclosure by lenders.