The Rise Of NAV Lending In Asia

Understanding NAV Loans And Subscription Line Loans

NAV Loans

NAV loans are credit facilities secured against the net asset value of a private equity fund’s portfolio, including the underlying investments of the fund itself and/or the cash flows, distributions, and other amounts received by the fund on account of those investments; they are therefore a form of debt financing at the fund level, where a lender or multiple lenders provide senior secured debt capital to a fund up to a specified loan-to-value (LTV) ratio.

NAV loans allow private equity funds to borrow against the value of their portfolio, providing liquidity for various purposes such as injecting liquidity into existing investments, bridging capital calls, funding distributions, or making additional investments. The primary advantage of NAV loans is that they enable a private equity fund to unlock the value of its assets without having to sell them, thus preserving the potential for further growth.

Subscription Line Loans

Subscription line loans, also known as capital call facilities or subscription credit facilities, are short-term credit lines secured by the uncalled capital commitments of a private equity fund’s limited partners (LPs), rather than by the underlying investments of the private equity fund. Subscription line loans provide immediate liquidity to a private equity fund which can then be used for making investments or covering operational expenses, with the expectation that the borrowed amount will be repaid when the capital is ultimately called by the private equity fund from its LPs. A subscription line loan is therefore also a form of fund-level financing.

Because subscription line financing has typically been offered by large banks for one- or two-year terms, the cost of such financing has historically been very low, with such subscription line loans having standardised structures based on a single LTV test. For example, such a subscription line loan must be borrowing base compliant, as determined by the LTV test, otherwise repayment can be accelerated by the bank to de-risk the loan.

The subscription line loan market has undergone a change in the past couple of years, as interest rates have increased and put pressure on the banking sector, resulting in some banks allocating capital only to their largest clients. However, at the same time, non-bank lenders such as insurance companies, have been increasingly willing to provide subscription line loans on a fixed rate basis and sometimes for longer terms, thereby offering more flexibility to private equity funds than banks have traditionally offered.

Specific Factors Driving The Increase

There are some specific factors which have been driving the increased use of both NAV loans and subscription line loans by private equity funds:

1. Growth in the Private Equity Market: The Asian private equity market has expanded significantly over the past decade, driven by robust economic growth, rising middle-class wealth, and increased institutional interest. This growth has led to larger private equity fund sizes and more complex portfolios, which has in turn necessitated more innovative financing solutions, such as NAV loans and subscription line loans, to both manage liquidity and optimise returns.
2. Improved Liquidity Management: NAV loans and subscription line loans offer private equity funds improved liquidity management. By accessing such credit facilities, private equity funds can bridge timing gaps between investments and capital calls, ensuring that they have the necessary funds to seize investment opportunities promptly. The additional liquidity is also valuable in a market where private equity funds are holding existing assets for longer periods of time, as it can see an investment through a difficult patch and allow the fund to wait for a better exit opportunity.
3. Enhanced Fund Performance: Subscription line loans, in particular, can enhance private equity fund performance metrics such as IRR. By delaying capital calls, private equity funds can keep uncalled capital commitments in their investors’ accounts for longer periods, thereby boosting the reported IRR of the fund. This is especially useful for private equity managers when looking to attract new investors and retain existing ones.
4. Regulatory and Market Developments: Regulatory changes and evolving market conditions have also played a role in the increased use of NAV loans and subscription line loans. In certain markets, regulatory frameworks have become more accommodating to these types of credit facilities, providing clarity and reducing uncertainty for both lenders and borrowers. The growing sophistication of the Asian financial markets has also facilitated the development and availability of such credit facilities to private equity funds.
5. Diversification of Funding Sources: NAV loans and subscription line loans allow private equity funds to diversify their funding sources beyond traditional equity and debt financing. This diversification can reduce reliance on capital markets and provide a more stable funding base, particularly during periods of market volatility.

Specific Benefits Of Using NAV Loans And Subscription Line Loans

There are a number of benefits for private equity funds:

1. Operational Flexibility: NAV loans and subscription line loans provide private equity funds with operational flexibility, and, as noted above, enable them to manage cash flows more effectively. This flexibility allows private equity funds to optimise the timing of investments, manage portfolio company needs, and address unforeseen expenses without disrupting the overall investment strategy of the fund.
2. Cost Efficiency: These types of credit facilities can be more cost-effective when compared to alternative sources of financing. For example, NAV loans often have lower interest rates than mezzanine debt or equity financing, while subscription line loans can reduce the frequency of capital calls, lowering administrative costs and improving investor satisfaction.
3. Maximising Investment Opportunities: With immediate access to liquidity, private equity funds can capitalise on investment opportunities as they arise, without waiting for capital calls to be fulfilled.
4. Investor Relations: By using subscription line loans to delay capital calls, private equity funds can improve their relationships with LPs, as investors may appreciate the ability to keep their capital invested elsewhere for longer periods, potentially earning additional returns before that capital is called upon.
5. Risk Management: NAV loans can also serve as a risk management tool by providing a liquidity buffer during economic downturns or periods of market stress. Such a buffer can help private equity funds navigate challenging market conditions without being forced to sell assets at unfavourable prices.

Potential Risks And Challenges

Notwithstanding the benefits in using NAV loans and subscription line loans, their use is not without risk.

1. Leverage and Financial Risk: The use of NAV loans and subscription line loans will increase the leverage within a private equity fund, which can amplify financial risk. Excessive borrowing could lead to higher interest expenses and potentially jeopardise the financial stability of the fund, particularly if its underlying assets do not perform as expected.
2. Valuation and Liquidity Risks: NAV loans are contingent on the valuation of the private equity fund’s portfolio, which will fluctuate over time and can be subjective. If the value of the portfolio declines, the private equity fund may face challenges in meeting loan covenants or repaying the loans. This risk may be compounded in less liquid markets, where asset sales may be difficult.
3. Impact on Fund Returns: While subscription line loans can enhance a fund’s IRR, they can also mask the true financial health of a fund by delaying capital calls, and may lead to an overestimation of fund performance, which could have implications for investors.
4. Complexity and Administrative Burden: Managing NAV loans and subscription line loans can require sophisticated financial management and reporting systems. The administrative burden associated with such credit facilities, including compliance and reporting requirements, can be significant and may require dedicated resources.

The increasing use of NAV loans and subscription line loans by Asian private equity funds reflects the evolving needs and strategies of those funds in the region. Whilst these types of credit facilities undoubtedly offer significant benefits, including improved liquidity management, enhanced fund performance, and operational flexibility, they can also introduce potential risks related to leverage, valuation, and regulatory scrutiny.

As the Asian private equity market continues to mature, the careful and strategic use of NAV loans and subscription line loans is likely to be essential when seeking to both maximise returns and manage risks effectively. Private equity funds will need to continue to balance the advantages of these types of credit facilities with prudent risk management practices to ensure their sustainable growth and long-term success.

Gavin Cumming
Mr. Cumming joined the firm in 2005 and has day-to-day responsibility for the firm’s non-contentious financial services practice. He is recognized by AsiaLaw Leading Lawyers as a leading lawyer in financial services regulation. Mr. Cumming has broad and deep experience in corporate, commercial and tax matters with a particular focus on strategic and operational initiatives of asset managers, investment banks, private banks and other wealth managers, insurance companies, broker-dealers and market infrastructure operators. He has a wealth of experience in electronic trading and clearing systems, the formation of private funds, including hedge funds and private equity funds, capital raising for funds, the authorization of public funds for sale to the retail public, private equity portfolio transactions, change of control transactions involving regulated financial institutions, and ongoing compliance issues for regulated financial institutions.