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Analysis Private credit
Alternative PE lending puts pressure on LP-GP alignment
by Lisa Fu, Tom Cane and Harriet Matthews
Loans that use fund NAV or GP earnings as collateral are growing in popularity. But some feel these deals could have unforeseen effects and hinder transparency in LP relationships
Private equity firms are pushing the envelope on how they use the proceeds of alternative lending facilities, raising questions about transparency and alignment with investors in their funds, say market participants.
Alternative lending to financial sponsors — which includes lending against portfolio companies at the fund level and general partners’ future earnings at the management company level — has become a hot private-credit strategy. It taps into rising demand from sponsors to unlock liquidity and institutional investors’ desire to fund loans with attractive risk-adjusted returns.
Fund-level loans, known as NAV facilities, are collateralised against the net asset value of investments owned by a fund. General partner-level debt is secured against cashflows that GPs stand to earn from managing a fund.
“As long as it’s in the betterment of the underlying fund or operating business or management company, I think anything is considered,” said Rob Bolandian, global head of investment banking at Cambridge Wilkinson.
NAV loans can be used for anything
Limited partners have been expressing concerns about fund-level NAV financing for some time, with some objecting to these facilities being used to make distributions. The use of GP-level financing in particular has been raising eyebrows. Potentially, a GP could borrow to pay bonuses to staff, or even help individual partners make personal purchases like houses — though market participants caution this would likely only work for a small fund with a few partners. One European alternative lender said this type of loan would be “miles more expensive than a mortgage”.
“You can take a loan against the carry where the guarantor is the management company (GP),” a US-based NAV lender said. “You can use that for anything. It can be a bit like the Wild West.”
Bolandian said typical use cases include securing working capital, funding an employee stock ownership plan or buying partners out of the GP. Sponsors can also borrow to fund a GP commitment for an upcoming fundraise when a lack of realisations or a planned uptick in fund size leaves a manager short of the capital required.
With GP-level loans, LPs have no or very little say as the management company is a separate entity from the fund, an industry banker said. LPs only control the amount of management fees they commit and have little say without a stake in the GP — but it is often these management fees that are being collateralised.
I think it’s rife with conflicts
Roger Vincent
Founder and CIO
Summation Capital
Since the structure involves a manager tapping into fees payable to the GP ahead of schedule, these facilities are in a way irrelevant to the fund and its LPs, an attorney in the space argued. “It has nothing to do with LPs’ credit risk directly or indirectly,” the attorney said. “There’s really a tenuous connection between putting in place a GP or management facility and the manager being able to manage the fund properly. I really don’t see a risk to the LPs.”
Still, LPs are always looking for greater alignment, and the way a GP-level loan is used can impact the dynamic between an investor and manager, said Roger Vincent, founder and CIO of Summation Capital. “When they take a GP asset that’s going to pay out sometime in the future and they celebrate that by getting a loan on it, they’re shifting the alignment in ways that are hard to predict or understand,” he said.
“LPs can decide the management company is not well-run, but they can’t say what they can and can’t borrow,” said the European alternative lender. “LPs should ask where the money comes from, and they don’t do it enough.”
NAV facilities at the fund level are often used to help a portfolio company make add-on acquisitions or deleverage its balance sheet, Bolandian said. Sponsors, facing a higher interest rate environment, can also use the facility to bridge a portfolio company to a refinancing.
NAV lenders can exclude certain use cases, but private credit lenders are under pressure to deploy, said a lender at a bank that provides alternative financing to private equity firms. Private credit NAV facilities are expensive and there are few deals, which leads lenders to grant flexibility to borrowers.
“Once the money is out the door, we don’t care how sponsors use it,” said an executive at an alternative lender during the Debtwire Private Credit Forum Europe 2024.
Reducing transparency
A different private credit executive said their firm is happy to provide subscription lines to PE firms but shies away from the NAV lending space to avoid having financial sponsors use the money to pay staff or fund other unusual activities.
The variability in use of proceeds and investors’ lack of familiarity with NAV lending has left LPs in PE and private credit loans looking for transparency.
“There have been people using [NAV financing] to repay debt at a portfolio company or to help execute an add on acquisition programme at another portfolio company,” said Vincent. “I’m not saying that these are wholly bad ideas. But they seem a little bit dangerous to me. For some reason, it always invokes the subprime crisis — levered bonds being levered again.”
This fund-level debt can result in sponsors cross-collateralising their portfolio, Vincent added. “It embeds a level of risk in the portfolio that LPs aren’t really signing up for,” he said. “I think it’s rife with conflicts.”
