Private Equity and Net Asset Value Debt – Ripping-Up the Rules of Private Equity

The Rules of Private Equity Leveraged Buyout Funds

The private equity leveraged buyout (LBO) is, unsurprisingly given the name, characterized by high levels of debt. Debt leverages returns for LBO funds, and also scales-up the size and number of investments a fund can make. However, debt used for LBO acquisitions is usually carefully managed – the fund itself does not customarily incur the debt. Typically, a fund will establish separate limited liability special purpose vehicles (SPVs) to acquire each portfolio company, with debt incurred by an SPV or SPVs in each case. Post-acquisition, the relevant portfolio company guarantees the repayment of the debt used for its acquisition. If there is a default on the acquisition debt, the relevant lender can only enforce against the assets of the portfolio company for which the debt was incurred to acquire, and cannot attach to any other assets of the fund, including any other portfolio company owned by the fund. The rules of private equity LBOs – no liabilities at the fund-level, and compartmentalize your portfolio investments into individual silos.

The Rise of NAV Debt

Tearing-up the rules of private equity, net asset value debt (NAV Debt) is debt incurred by a private equity fund at the fund-level. To be sure, fund-level subscription facilities that tide funds over while awaiting drawdowns under capital commitments from limited partners already blur the rules of private equity. Subscription facilities, however, are merely short-term in nature, swiftly paid-off from contributions made by limited partners.  In contrast, as discussed in my new paper, “Private Equity and Net Asset Value Loans: Ticking Time Bomb or Ticking All the Right Boxes”, NAV Debt is a different beast. NAV Debt is long-term debt either incurred by the fund, or incurred by an SPV and effectively guaranteed by the fund, backed-up by the net asset value of all the portfolio companies of the fund. NAV Debt has been taking the LBO industry by storm.  Already a $100 billion industry in 2023, lenders have enthusiastically predicted that the industry will be worth $700 billion by 2030. Whereas NAV Debt was once the preserve of small, and desperate, LBO funds, it is now widely utilized by some of the most prominent megacap private equity sponsors around the world.

Why NAV Debt?

An extended period of high interest rates, and a concomitant decline in exit values, has precipitated the rise of NAV Debt. In the paper, I divide the use cases into three forms – offensive, defensive and liquidity.

Offensive NAV Debt is incurred by the fund primarily to enable existing portfolio companies to complete acquisitions of related businesses (bolt-on investments), or to refinance debt nearing maturity. Debt at the fund-level may be cheaper than at the portfolio company-level since it is backed-up by a greater spread and size of assets, making it particularly beneficial to the fund at a time when debt is likely more costly than when the fund made the original acquisition.

Defensive NAV Debt is incurred to shore-up poorly performing portfolio companies, either to cure events of default under existing acquisition debt, or to refinance acquisition debt where a portfolio company is struggling to generate sufficient cash-flow to maintain interest payments. Interest on NAV Debt is often capitalized and compounded by being payable as payment in kind (“PIK”) notes, facilitating the ongoing survival of a portfolio company with cash-flow problems.

Liquidity NAV Debt is incurred to make distributions to investors.  The cash is simply mainlined straight up to the limited partners of the fund. Ostensibly, the approach stems from a logjam in exits. With a decline in exit values, what sellers want for their investments is more than what buyers are willing to pay. Much like continuation funds, NAV Debt allows the fund to extend holding periods and avoid sales at rock-bottom prices, by ensuring that limited partners continue to receive distributions even when exits are not taking place. In some respects, NAV Debt keeps the LBO business model rolling. Regular distributions to limited partners, who may otherwise be bumping-up against their internal private equity allocation limits, frees-up cash for them to invest in successor funds established by the private equity sponsor.

The nascent NAV Debt industry has regularly extolled the benefits summarized above, and NAV Debt could be considered to be an innovative solution to a testing time for the current vintage of LBO funds that made acquisitions at a time of historically low interest rates, valuing them on a basis that did not contemplate the higher cost of debt that would follow and its impact on exit prices. All good?  Not quite. NAV Debt brings with it a variety of potential costs.

The Costs of NAV Debt

In the paper, I discuss in detail four categories of potential costs – contagion risk, motives driven by private benefit extraction, governance challenges, and financial manipulation concerns. These are summarized below.

NAV Debt is backed-up by the all the assets of the fund.  Although due to the terms of existing acquisition facilities it is often impractical to secure NAV Debt against either the assets of each portfolio company or even the stock of the SPVs holding those portfolio companies, NAV Debt will be secured against any distributions arriving at the fund-level. The NAV Debt will include a financial covenant that provides that if the net asset value of the portfolio falls to an extent that the “loan-to-value” (LTV) of the NAV Debt exceeds a specified threshold, the fund will be required to cure the default to ensure that the LTV once again falls below the threshold.  With the cross-collateralization of assets created by NAV Debt, if one or more portfolio companies let the team down and trigger LTV covenant breaches, the fund could, in extreme circumstances, be required to sell healthy investments to cure the breach. Essentially, good investments subsidize bad investments. Whereas in the past the fund could write-off or put into bankruptcy failing investments without consequences to returns from other portfolio investments, now with contagion risk, returns across the fund could be impacted. 

Private benefit extraction by general partners of funds may also be at least a partial motivation for the incurrence of NAV Debt.  In particular, liquidity NAV Debt can accelerate the receipt of the general partner’s performance-based remuneration – the “carry”. Most of the current vintage of LBO funds will not have expressly contemplated the deployment of NAV Debt, and distributions “generated” through NAV Debt will be treated under limited partnership waterfall provisions in the same way as distributions from exits. For a general partner starved of carry during the exits logjam, liquidity NAV Debt provides respite, but at the cost of lumbering the fund with debt and costly interest which could hammer future returns. The general partner may also be inspired to use liquidity NAV Debt or defensive NAV Debt to ensure that assets under management stay higher for longer, drawing-out management fees over an extended period of time. Furthermore, as alluded to above, the altruism of general partners when causing a LBO fund to incur liquidity NAV Debt may be doubted when employed at a time of fund-raising for a successor fund. General partners may plead that liquidity NAV Debt is a response to limited partners crying-out for returns, but, in fact, the reality may more grounded in a desire of general partners to ensure the success of their latest fund, potentially to the detriment of the predecessor fund.

A plethora of academic literature speaks to the governance benefits of the private equity model over publicly-traded companies that could drive the performance of private equity-backed portfolio companies. Many of those governance benefits are, however, undermined by the use of NAV Debt. For example, one of the benefits of an LBO model that prioritizes debt is that in the normal course the interest of acquisition debt can be deducted from the profits of the portfolio company it has been used to acquire for the purposes of determining corporation tax. Such a “tax shield” will not in most cases be available when NAV Debt is utilized, since the vehicle incurring the NAV Debt will not form a tax group with any particular portfolio company. Moreover, in the case of offensive NAV Debt for bolt-on investments, due to interest on the debt being paid as PIK notes, at the level of the portfolio company making the acquisition, LTV will be less than prior to the acquisition, diluting the disciplining effect of debt otherwise espoused as a substantive governance benefit of private equity in seminal work by Michael Jensen. Additionally, by enabling funds to delay exits, NAV Debt, like continuation funds, lengthens the period during which general partners would normally be under pressure to exit investments. With less pressure on general partners, there is a dilution of the incentive to ensure that portfolio companies become more profitable as soon as possible. Time will tell whether those modified governance dynamics result in poorer returns from funds that incur NAV Debt.

Finally, certain types of NAV Debt can reflect a level of intentional or unintentional financial engineering on the part of general partners.  Liquidity NAV Debt, or offensive NAV Debt incurred to avoid calling commitments from limited partners, increases the internal rate of return (IRR) of the fund, since, respectively, either limited partners are receiving cash earlier or they will have less cash contributed to the fund when returns are made. If a general partner is in the midst of successor fund roadshows, increasing the interim IRR of the predecessor fund can be beneficial to the success of the new fund-raising. Without sufficient disclosure of the use of NAV Debt, and full transparency as to how interim performance metrics have been determined, prospective limited partners in new funds may not be seeing the full picture. Even with disclosure, when NAV Debt has been utilized for multiple purposes at different times, it becomes increasingly challenging to see the wood for the trees.

Limited Partners Beware!

NAV Debt is not a monolith, and some types, such as offensive NAV Debt, are more benign than the more controversial uses, such as liquidity NAV Debt. However, all types of NAV Debt create contagion risk. Although uncurable mass fund defaults in the private equity industry are unlikely, since NAV Debt lenders lend on a conservative basis with LTVs only a fraction of the total net asset value of fund portfolios, NAV Debt still represents a risky gamble by private equity sponsors. The wager is on interest rates falling and falling quickly (thereby resulting in higher exit values, curing the exit logjam) before the end of the lifetime of the relevant fund. If that does not happen, the fund will have doubled-down on the poor economic environment for private equity and the fund’s eventual returns will be substantially depressed. Whether the gamble pays-off is for future research.

Going forward, with newly established funds, limited partners will have to be savvier when it comes to NAV Debt. Limited partnership agreements will need to contemplate its use and investors will need to determine whether consent rights should be included for the use of NAV Debt. Disclosure obligations will be vital, and limited partners require insight into regular financial statements to ensure that they can determine general partner performance with and without the cheat code that is NAV Debt. More challenging is the interplay between NAV Debt and the general partner’s carry – consideration should be given to whether a general partner should immediately receive a carry generated through a liquidity NAV Debt distribution when the distribution does not reflect the skills of the general partner or the performance of the portfolio. The Institutional Limited Partners Association (ILPA) has announced it will publish a report on NAV Debt together with recommendations for limited partners. With ILPA endorsement, limited partners may feel more emboldened to push for greater rights in limited partner agreements. Additionally, prior to the recent decision of the fifth circuit, the SEC had proposed that private funds would be required to produce quarterly reports with performance disclosed on a basis including and excluding subscription facilities. If the rule were to be resuscitated, a simple, but fruitful, amendment would be to also require performance to be disclosed ex-NAV Debt.

What for the future? NAV Debt is really a manifestation of a vintage of funds hit by a sudden and unexpected drastic rise in interest rates. The exit values envisaged at the time of acquisitions have evaporated in a plume of smoke, with NAV Debt entering the picture in an attempt to save face. Although much hype has surrounded the potential for NAV Debt to become a standard feature of the market, much of the commentary originates from market players with an interest in normalizing its use. It is incumbent on limited partners to ensure that NAV Debt remains as merely a response tool in the event of economic shocks, rather than becoming ingrained within the customary private equity LBO model. The concept of NAV Debt is not rocket science, but it is only recently that it has been employed on a prevalent basis. There is a reason why the private equity rules have existed without disruption for decades, and limited (and general) partners should be cautious before brazenly ripping them up.  

The complete paper is available for download here.