Historically, fund managers with more concentrated portfolios tend to have higher average returns than those who are more diversified. Funds with 1-7 assets have historical average net IRRs of c.29%, whereas funds with more than 7 assets have average net IRRs of c.19%. The difference in returns between concentrated and diversified portfolios is further exacerbated in top quartile funds. Top quartile funds which have 1-7 assets have historical net IRRs of c.41%, however top quartile funds with more than 7 assets have an IRR of 23%.
However, bottom quartile funds with concentrated portfolios have lower levels of returns than bottom quartile funds with more diversified portfolios. Bottom quartile funds which have 1-7 assets have historical net IRRs of c.11%, in contrast, bottom quartile funds with more than 7 assets have an IRR of c.13%. Hence, we can conclude that more concentrated portfolios have a higher volatility in returns and lower levels of downside protection.
By leveraging solutions like NAV lending to acquire an extra portfolio company, General Partners (GPs) with concentrated portfolios can further enhance their returns by investing capital at cost of debt, while obtaining equity like returns, whilst effectively mitigating the risk associated with portfolio concentration as a result of being exposed to more companies. To exemplify our argument, we present a case study of how a fund can use NAV loans to finance the acquisition of a new platform below.
A Nordics private equity buyout fund investing across multiple sectors has holdings in six companies on its second fund, where it has invested €190MM out of €200MM committed. Currently the fund is trading at c.1.5x gross MoC and it is on track to achieve a 2.5x gross MoC. The fund has identified a compelling investment opportunity in a new platform it seeks to acquire. The projected capital requirement for this acquisition is approximately €24MM and the company is expected to generate a 3.0x gross MoC under the GP’s base case. However, with >90% of its capital already allocated to existing portfolio companies and the remaining required to pay off fund expenses, the fund lacks the necessary capital to pursue this new investment.
To execute this transaction, the fund is exploring using an NAV loan. This would enable the fund to employ the collective value of its existing portfolio as collateral, securing more favorable financing terms. NAV lending would offer a significantly lower cost of capital compared to other financing alternatives, such as mezzanine loans and allow the fund to carry out the acquisition without diluting its existing equity holdings. Using the NAV loan, the fund can invest in the new platform and increase the fund’s overall outturn to 2.7x gross MoC.
Considering a downside scenario where the new platform strongly underperforms expectations, the returns of the fund remain minimally affected. Assuming this 7th platform is only able to generate 1.4x MoC at exit, overall returns remain at 2.5x gross MoC, the same as the original outturn. This is due to the nature of the NAV financing where, as long as the proceeds from the exit are more than the total debt service of the loan, it will be value accretive towards the fund.
On the other hand, in a scenario where the new platform outperforms its expectations, it can be highly value-additive towards the fund’s overall returns. For instance, assuming an exit at a c.5.0x MoC, the funds’ overall returns increase to 3.0x MoC. Thus, NAV financing can offer the potential for significant return uplift while effectively mitigating the risks typically associated with underperforming investments and concentrated portfolios.
Qualitas Funds has awarded an NAV facility to a fund manager that was looking for capital for a variety of uses, including acquiring a new platform. The manager had a fund with 6 assets and identified a target operating in a highly fragmented market with opportunity for consolidation, a differentiating value proposition with cross-selling potential, an experienced and proven management team and an attractive entry valuation. The GP is looking to use the loan to finance this acquisition, along with some add-ons and follow on investments in other portfolio companies, effectively enhancing its fund-level returns and mitigating its portfolio concentration risk.
Recently, Qualitas Funds has launched a dedicated NAV lending strategy and is co-investing with Hark Capital in these loans. Hark Capital is a New York based fund which is specialized in NAV lending, active in this market since 2013 and having deployed c.€1.4BN in over 130 NAV loan operations without suffering any write-offs. The previous deal marks Qualitas Funds’ second NAV lending operation and its timing coincides with the opening of our first NAV financing fund, Qualitas Continuation Finance I, which is now open to professional investors. The fund will seek authorization from the CSSF for the ELTIF label, which would enable it to be available to retail investors, subject to certain conditions.
We are seeing increasing deal flow in the NAV lending space, driven by higher demand from fund managers for this type of solutions, and we believe this strategy exhibits strong synergies with our flagship fund of funds and co-investment strategies and reinforces our ethos to be the preferred provider of capital for, and give our investors access to, the best lower mid-market European private equity managers.
Notes
Note 1: Source: Qualitas Funds’ analysis using data from Qualitas Insights database, covering all funds with European headquarters and European investment focus.
Note 2: Source: Qualitas Funds case study based on our NAV deal pipeline.