What it means
Funds have traditionally borrowed in two ways. A subscription line is secured on undrawn investor commitments and used for short-term bridging in the early years, while a NAV facility is secured on the portfolio itself and used in the later years once those commitments are exhausted.
The shift from one to the other tracks the natural life cycle of a fund. Managers use these facilities for a handful of practical reasons: funding a follow-on investment in an existing company, paying an interim distribution to investors while waiting for a better selling environment, or covering fund expenses without a forced sale.
The common thread is buying time, since the alternative is usually to sell an asset earlier or cheaper than the manager would like. The size of the loan comes from the fund's net asset value multiplied by a loan-to-value percentage the lender is willing to accept.
In private equity that percentage is typically low, often somewhere between 5% and 25%, because the collateral is a set of illiquid holdings whose values are estimates rather than market quotes. Diversified portfolios of cash-generating companies attract better terms than concentrated ones.
The main risk is that the collateral is marked, not traded. If portfolio valuations fall, the loan-to-value ratio rises even though nothing has been sold, and a covenant breach can force the manager to repay, post more collateral or sell assets into a weak market.
That is the scenario every credit committee models before approving a facility. The practice is also contested on governance grounds.
Borrowing against the portfolio to fund distributions returns cash to investors sooner and improves the headline internal rate of return without any asset actually being sold, which some investors regard as flattering the numbers. Most limited partnership agreements now set explicit limits, and disclosure of NAV borrowing has become a standard investor request.
In practice
Real-world examples
Example 1
A growth fund in its ninth year wants to put a further $60,000,000 into its strongest portfolio company ahead of a sale, but its investor commitments are fully drawn. It borrows against the wider portfolio at 10% loan-to-value and repays the facility from the eventual exit proceeds.
Example 2
A property fund faces a slow transaction market and does not want to sell two assets at distressed prices. It draws a NAV facility to make a $45,000,000 interim distribution and clears the loan eighteen months later when buyer appetite returns.
Example 3
A secondaries investor buys a portfolio of fund stakes and uses NAV financing to cover part of the purchase price. The lender sets a low loan-to-value because the underlying holdings are spread across dozens of funds and sectors.
Think of it
NAV financing is borrowing against your portfolio value-loans on fund assets.
Formula
Calculation
Loan capacity = fund NAV x maximum loan-to-value ratio, and the covenant headroom is the fall in NAV that would push the ratio to its limit.
A buyout fund holds twelve companies with a combined net asset value of $1,200,000,000. A lender offers a NAV facility at 15% loan-to-value, so capacity = $1,200,000,000 x 0.15 = $180,000,000. Interest is charged at 9%, giving an annual cost of $180,000,000 x 0.09 = $16,200,000. The facility carries a covenant that loan-to-value must stay below 25%. The NAV at which that limit is hit = $180,000,000 / 0.25 = $720,000,000, so the portfolio could fall from $1,200,000,000 to $720,000,000, a decline of $480,000,000 or 40%, before the covenant is breached. That 40% cushion is what the credit committee is really pricing.Case study
Seen in the real world
Cedar Point Partners is an entirely fictional buyout manager used to illustrate how these facilities behave. In year eight of a ten-year fund it held six remaining companies valued at $900,000,000 and had no undrawn commitments left, while investors were pressing for cash after a long gap between distributions.
The manager arranged a $90,000,000 NAV facility at 10% loan-to-value with a 20% covenant limit, distributed $75,000,000 and kept the rest for fund expenses. When a broader market correction cut portfolio valuations by roughly 18% the following year, NAV fell to about $738,000,000 and the loan-to-value ratio rose to just over 12%, uncomfortable but well inside the covenant.
Cedar Point sold one company eleven months later and repaid the facility in full. The illustrative lesson is that the headroom, not the headline rate, is the number that matters: the same distribution funded at 20% loan-to-value would have left the manager negotiating with its lender in the middle of a falling market.
Watch out
Common mistakes
- Confusing a NAV facility with a subscription line. One is secured on portfolio assets, the other on investor commitments, and they carry very different risks and pricing.
- Judging the deal only by the interest rate. Covenant levels, cure rights and the valuation policy behind the collateral usually matter more than a percentage point of margin.
- Treating a distribution funded by borrowing as realised performance. Nothing has been sold, the loan still has to be repaid, and the internal rate of return has been flattered by the timing.
Questions
People also ask
Why is the loan-to-value ratio so low?
Because the collateral is illiquid and valued by estimate, so the lender needs a wide cushion against both a market fall and a valuation that turns out to have been optimistic.
Do investors have to approve NAV borrowing?
Usually the limited partnership agreement sets a cap and disclosure requirements, and anything beyond that needs consent from the advisory committee.
What happens if a covenant is breached?
The manager typically has a cure period to repay part of the loan, add collateral or use exit proceeds, and failing that the lender can force asset sales.