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One aspect of NAV loans that lenders often focus on is the risk
of “bad acts” by a borrower with respect to the
investments that underpin the loans. For our purposes, NAV loans
are loans to alternative investment entities (e.g.,
private equity funds, secondaries funds, hedge funds, funds of
hedge funds, pension funds and family office vehicles) that are
underwritten, either on a secured or unsecured basis, by the value
of the entity’s investments. When entering into NAV loans,
lenders assess the investments owned by the borrowers at closing
and then continue to monitor such investments after closing for
compliance with financial covenants and other loan requirements.
Unlike other types of securities financings (think prime brokerage,
securities lending and repo, or typical bank margin loans), where a
lender or a third-party custodian on behalf of the lender holds or
controls the securities on which the loans are underwritten, the
underwritten assets in NAV loans are typically owned and controlled
by the borrower, either directly or through one or more subsidiary
holding vehicles. Further, even in secured loan facilities, the
investments themselves often are not pledged to the lenders
directly by the borrower. Instead, the investments are typically
owned by subsidiary holding vehicles the equity interests of which
are pledged to the lenders as collateral for the loan
(i.e., an “indirect pledge” of the investments).
See a previous discussion of some of the issues associated with
indirect pledge structures here. As a result, the borrowers (directly or
indirectly) typically maintain complete control over the assets
that the lenders are underwriting.
On top of the “market risk” inherent in NAV loans
(i.e., the risk that the value of the borrower’s
investments will decline), because a borrower typically remains in
control of its investments, such structures involve a degree of
“bad acts” risk. For our purposes, “bad acts”
refer to actions by the borrower that cause or result in the
investments ceasing to be owned by the borrower, or becoming
subject to the claims of other creditors, in each case in
contravention of the terms of the NAV loan. In this article, we
briefly discuss factors that lenders analyze in evaluating the risk
in NAV loans of the potential for these bad acts by borrowers.
These factors broadly include (i) the profile of the borrower; (ii)
the scope of the lenders’ relationships with the borrower; and
(iii) the nature of the investment portfolio on which the loan is
underwritten.
Profile of the borrower. One of the key factors
that lenders consider in evaluating bad act risks with respect to
NAV loans is the market profile of the borrower, or more
specifically, the borrower’s sponsor. Lenders may evaluate
factors such as:
- Frequency of use of financing: Certain sponsors are
serial users of financing such that the use of financing is an
integral part of the sponsor’s business model. An example would
be a secondaries sponsor that consistently employs financing to
acquire portfolios of private equity interests in the secondaries
market. Lenders may take comfort from the fact that such a sponsor
has a verifiable track record of responsible use of NAV loan
financing. Further, lenders may view the sponsor’s continued
need for financing to operate its business as an effective
incentive to avoid defaults under the sponsor’s existing
financings, particularly as a result of bad acts. - Breadth of the sponsor’s “brand”:
Certain sponsors have brands that expand well beyond the fund
involved in the particular financing. Such sponsors may be
affiliated with larger financial institutions, or may have
extensive asset management platforms encompassing a broad range of
investment strategies, products and asset classes. Lenders may take
comfort in the resources such platforms have dedicated to
monitoring and compliance, and may perceive sponsors on such
platforms to be more averse to the type of negative publicity and
reputational harm to the sponsor’s overall brand that would be
associated with any bad acts. - Sources of equity capital: Lenders often take comfort
from a sponsor’s management of a significant amount of external
money. External capital (and particularly institutional capital)
can act as a check on certain types of behavior. Lenders may be
concerned that investment entities with captive sources of capital
(such as family offices, by way of example), may evaluate potential
consequences of a financing default solely in the context of a
specific transaction and lender relationship, whereas sponsors
beholden to large and sophisticated external investors may be
forced to account for broader consequences (e.g., the need
to raise additional capital for future fund launches).
Relationship between the lenders and the
borrower. Another key factor that lenders consider in
evaluating bad act risks with respect to NAV loans is the
lender’s overall relationship with any given borrower or
sponsor. Financings are often entered into with alternative
investment entities in the context of a much broader relationship
between the lenders and the sponsors of such entities. NAV loans
are not always viewed as profitable on a standalone basis. Instead,
they are often a part of a package of services offered by the
lenders to broaden or deepen engagement among the sponsor, the
lenders and their respective affiliates. Where a sponsor has
extensive touch points with a lender and its affiliates, comfort
may be taken that a financing transaction with such sponsor is less
prone to bad acts given the extent of a lender’s familiarity
with a sponsor and its principals and the sponsor’s reliance on
the other services provided by the lender.
Characteristics of the investment portfolio.
Finally, lenders may also consider the impact of the
characteristics of a borrower’s investment portfolio on the
risk of any bad acts. While the characteristics of a borrower’s
investment portfolio might not make the likelihood of bad acts more
or less likely, as with market risk, a concentrated portfolio
raises the stakes to lenders in the event of any impairment of the
portfolio, including any bad acts. As a result, the consequence of
a bad act with respect to a single investment in a well-diversified
portfolio is likely to have less dire consequences for a
lender.
Notwithstanding the inherent risk of “bad acts” in
certain NAV loan structures as discussed above, there are still
various tools that lenders can employ to mitigate these risks (some
more onerous for borrowers than others). We will discuss those
tools and how they act to mitigate the bad acts risk on another
Friday.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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