September 2024
In previous articles we focused on the use of NAV loans for funding the acquisition of portfolio company add-ons. This is one of several “offensive” use cases for NAV loans, which can also include financing of capex or working capital to fund the expansion of profitable companies that want to grow.
GPs can also use NAV financing for defensive use cases like refinancing debt at company level. The main benefit of this is access to debt at more affordable rates than mezzanine loans, as the collateral is at the portfolio level rather than at the company level. Using NAV lending also typically improves the liquidity profile of the companies, as part of the interest is paid in a PIK format, as opposed to loans with an all-cash interest. Refinancing debt also has the added benefit of increasing covenant headroom, as the NAV loan proceeds are used as equity to pay some of the company level debt. Covenant flexibility is also improved as NAV loans typically do not have any company level covenants, increasing the flexibility with which fund managers can run their underlying portfolio company.
In order to better exemplify our argument, we present a hypothetical example of how a fund can use NAV financing to refinance debt of a portfolio company. A Nordics private equity buyout fund investing across multiple sectors has holdings in seven companies on its second fund, and currently has a total NAV of €300MM. The fund is currently facing risks associated with the financial covenants of one of its portfolio companies, which sells consumer staples in the Swedish market.
Despite a solid performance in the first year after the acquisition, unfavourable market conditions and rising interest rates have led to an increase in mortgage payments for the Swedish population, most of whom have variable rate loans. This has reduced the disposable income of the country’s population and caused a significant drop in demand, negatively affecting the company’s sales.
The company already exceeded its covenant Net Debt/EBITDA ratio of 5.0x in the second year, however, it managed to negotiate a covenant waiver with its creditors. The company is on track to breach the covenants again in the third year, exposing it to a second breach. In this scenario, the loan would likely go into default and the fund would lose a significant portion of its invested capital.
Faced with these challenges, the fund manager began searching for financing solutions to address these solvency issues and prevent the company from defaulting on its covenants. It is exploring fund-level financing to repay the company’s debt or, alternatively, opting for an additional capital injection.
Either of these solutions would be used to repay the current mezzanine loan of c.€30MM, as it has a very significant impact on its free cash flow due to its high effective interest rate of 12%. Repaying this debt would allow the company to meet the financial covenants in year 3. The company’s total debt position would be reduced from c.€70MM to c.€40MM. This would decrease the Net Debt/EBITDA ratio from 5.8x to 3.4x, which would allow the company to maintain its solvency position and gain plenty of covenant headroom.
Out of the two solutions, the equity injection alternative would have a higher cost of capital. If the refinancing is funded through a co-investment, it would also have more associated risks for new investors, as the valuation would likely happen at a higher multiple than that of entry, due to the expectation for the company’s financial position to go back to previous financial results. Also, if it is partially funded through undrawn fund commitments, it also reduces the capital available for other investments.
On the other hand, NAV loans have a lower cost of capital than the equity injection and results in no implied dilution for existing fund investors. Despite it being a debt like facility, it helps to significantly increase the liquidity of the company, as its cash interest component is c.50% of the overall interest rate of the loan, implying the payments of lower interest rate premiums. Additionally, the covenants put in place as part of the NAV facility are at the fund level, so they would not restrict the operations of the company in any way.
Hence, using NAV to refinance the company is projected to generate a gross MoC of 2.6x and a gross IRR of 15%, compared to the equity injection, which would only generate a gross MoC of 2.4x and an estimated gross IRR of 13% if the business plan is achieved.
The higher base case returns make NAV loans a very interesting solution to help provide funding for the refinancing of debt at the company level. As a result, LPs generally have a positive opinion on this use case for NAV lending. According to a study by Rede Partners, 71% of LPs have expressed a positive or neutral opinion on the use of NAV finance by fund managers to fund company level refinancings.
This case study highlights the versatility of NAV loans, which can be used to fund multiple types of defensive or offensive equity like use cases with a debt cost of capital. This makes them highly value accretive compared to traditional equity financing, resulting in the high appetite from managers and investors in using these solutions for value creation use cases.
Notes
Note 1: Sourced from Qualitas Funds’ analysis.
Note 2: Sourced from Rede Partners report “NAVigating NAV Financing”.
