NAV Covenants And Subscription Lines – Finance and Banking

For funds that are nearing the end of their investment period
and have limited or no remaining unfunded capital commitments, the
need to continue a subscription line facility for ongoing liquidity
may continue to exist for these end-of-life funds to support
follow-on investments, reoccurring fund operational expenses, and
costs associated with maintaining and liquidating their portfolio
investments. There are a number of financing options in the fund
finance market for these funds to consider, including net asset
value (NAV) and hybrid credit facilities, but, for many funds, the
convenience and familiarity of their existing subscription line
credit facility may continue to remain the most efficient and
expeditious way to extend their liquidity runway. In order to
prolong an existing subscription line facility to a fund after its
investment period, there are a number of important threshold
factors that a lender must consider, including the purpose for
which the general partner may call capital − which is usually
limited and excludes calling capital for new portfolio investments
not already under mandate − and whether the limited
partnership agreement permits the fund to incur and repay
post-investment period from the proceeds of a capital call,
including recallable capital if permitted by the limited
partnership agreement. In addition, structural changes are often
made to the subscription line loan agreement as the lender looks to
the portfolio investments of the fund and the underlying cash flow
from distributions from such investments to support the ongoing
credit facility. These structural changes almost always include the
implementation of NAV-style covenants, including a loan-to-value
(LTV) ratio or a minimum net asset value, NAV to portfolio cost,
and a mandatory loan repayment feature from fund
distributions. 

NAV-based credit facilities

We have seen an increased interest in NAV-based credit
facilities over the past few years as funds look to extend and
leverage the equity value of their portfolio investments. NAV
credit facilities are particularly attractive to later stage funds
approaching or at the end of their investment period with little to
no remaining unfunded capital but intend to participate in
follow-on investment strategies and have ongoing fund maintenance
needs. While the collateral for a subscription credit facility is
supported by the unfunded capital commitments of the fund’s
investors, collateral for NAV-based credit facilities are often
structured to include distributions and liquidation proceeds from
the fund’s portfolio investments and the rights to receive
such amounts, and a pledge of equity interests of the companies
holding the investments. A NAV facility will look
“downward” for collateral support in contrast to a
subscription facility that will look “upward” for the
collateral. Unlike subscription lines that have a revolving credit
facility structure with short-term tenors and are financial
covenant light, a NAV facility will usually consist of a term loan
facility with varying tenor lengths depending on the underlying
investments and at least LTV covenants that vary based on the
diversification of the portfolio assets and a mandatory repayment
feature that requires the fund to use all or a significant portion
of distributions received from the portfolio investment to prepay
outstanding obligations of the NAV credit facility. These
structural features, together with more expensive pricing for NAV
credit facilities, are generally less favorable terms for fund
borrowers when compared to their existing subscription line credit
facilities. 

Hybrid credit facilities

As with NAV-based credit facilities, there has been a
corresponding increase in hybrid credit facilities or subscription
facilities structured with NAV covenants. Hybrid credit facilities
are also particularly useful for funds that are nearing the end of
their investment period and have only a small amount of uncalled
capital or are dependent on recallable capital for follow-on
investments and fund expenses. The collateral pledged to secure
hybrid credit facilities typically includes a blend of fund assets
from looking “upward” to any remaining unfunded
commitments and recallable capital if permitted by the limited
partnership agreement and “downward” to the value of
the fund’s portfolio investments. Similarly, a hybrid credit
facility will include a combination of both subscription and
NAV-style covenants, making sure there is sufficient callable
capital and a minimum net asset value to support the credit
facility. These features increase the complexity of a
lender’s underwriting to a hybrid facility and the
corresponding legal diligence performed by lender’s counsel.
Pricing for hybrid facilities tends to be higher than subscription
facilities but lower than NAV facilities. A hybrid credit facility
provides ongoing liquidity and flexibility for maturing funds under
a single credit agreement. Even with this flexibility, funds may
decide that it is more efficient to continue with the subscription
credit facility with enhanced structural elements, such as
NAV-style covenants, added by the lender to support the extension
of the loan past a fund’s investment period when the value of
the portfolio becomes an important secondary source of
repayment.

Subscription line NAV covenants

For funds with ongoing liquidity needs after the expiration of
their investment period, and if NAV or hybrid facilities are not a
great fit, some lenders will agree to extend a fund’s
existing subscription line facility subject to certain supplemental
credit enhancements, including adjustments to the borrowing base
and the implementation of NAV-style covenants. An extension of a
traditional subscription facility, even with these adjustments, in
some cases, may be more beneficial to a fund than restructuring
into a NAV or hybrid facility. The fund is already familiar with
the covenants and reporting requirements of the existing facility
and has established a working relationship with a lending team over
the life of the facility. The lending team knows the fund
administrative team well and works closely with them and the
general partners in managing all aspects of the relationship. This
rapport is invaluable and not always easy to replicate. 

Significant adjustments to the borrowing base are typically
needed to increase availability to the fund when the remaining
uncalled capital is low or the fund only has recallable capital to
include in the borrowing base. A substantial increase in the
borrowing base from a traditional blended advance rate of 50% up to
90% is not uncommon. In return for this increase to the borrowing
base availability, lenders typically require the implementation of
NAV-style covenants to mitigate against the reduced primary source
of collateral and repayment in the form of uncommitted capital and
look “downward” at the asset value of the portfolio
investments. The NAV covenants are designed to be tight but should
be manageable and customized appropriately for the fund. The
typical NAV-style covenants include one or more of the
following:

LTV Ratio. A minimum LTV covenant will measure the ratio
of the principal amount of the credit facility to the value of the
portfolio assets held by the fund. The covenant may require that
the fund maintain a minimum net asset value across a select
grouping of trophy investments or across the fund’s entire
portfolio of investments. Having a diversified mix of underlying
portfolio investments is another important factor for this
covenant. Generally, lenders look more favorably on a broad
diversification of portfolio investments to minimize the increased
risk associated with continuing to extend credit to a fund with
diminished uncalled capital. A more diversified portfolio of loans
may permit a fund to obtain better loan terms and less restrictive
covenants when compared to funds with less diverse portfolio
investment holdings. A minimum LTV multiple of at least 25% to 35%
is customary for primary PE funds.

NAV-Cost. A fund may also be required to maintain and
report a NAV covenant tracking the fund’s aggregate cost
assigned to its portfolio investments as reflected on its most
recent financial statements. It is important for a lender to track
the fund’s ongoing cost structure and require that the fund
maintain expenses at reasonable levels to protect against
unanticipated depletion of the remaining uncommitted capital or
recallable capital, if applicable. A typical NAV-cost covenant will
require a NAV of at least 100% to 110% of the aggregate cost basis
assigned by the fund to its portfolio investments. 

Mandatory Repayment. The credit agreement may require the
fund to prepay any outstanding obligations with the proceeds from a
distribution or liquidation of a portfolio investment. In a
traditional subscription line facility, distributions and proceeds
received by the funds from its portfolio investments are considered
a secondary source of repayment for lenders. This secondary source
of repayment becomes more important as a fund’s uncommitted
capital is depleted over the life of the fund and the lender looks
“downward” into the portfolio investments to support
the ongoing liquidity needs of the fund borrower. As a result, it
is not uncommon to have a lender require a mandatory repayment of
the outstanding obligations under a subscription line credit
facility with the cash flow from distributions received by the fund
from its portfolio investments.

Even with the addition of these NAV-style covenants, the
convenience, familiarity, and efficiency of continuing a
subscription line credit facility may be the most beneficial and
preferred approach for both the fund and the lender to support the
ongoing liquidity needs of funds nearing the end of their natural
investment period.

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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