Subscription facilities and net asset value (NAV) facilities serve as strategic financing tools for private fund sponsors, providing flexibility across various stages of a fund’s lifecycle. While many partnership agreements provide for the use of such facilities—whether subscription facilities utilized early in a fund’s lifecycle or NAV facilities utilized later in a fund’s lifecycle after subscriptions have been called—communicating with investors (LPs) and justifying their value to LPs can be a tough task for sponsors. For example, LPs may be less familiar with such credit lines than sponsors, may doubt their utility, or may perceive various risks and drawbacks as reasons to avoid credit lines entirely. However, when used appropriately, subscription facilities and NAV facilities can significantly benefit both sponsors and LPs, and should be considered viable options to help optimize costs and enhance operational efficiency without overburdening LPs.
In the early stages of a fund’s life, subscription facilities can reduce the frequency of capital calls and, accordingly, help LPs manage cash flow while sponsors can benefit from being able to draw cash more quickly and reliably, thereby simplifying the fund administration process with regard to having available capital. Later on in the fund’s lifecycle, NAV facilities can provide (x) timely cash infusions to portfolio companies while avoiding the immediate need for follow-on investments from LPs, or (y) in some cases, partial distributions to LPs. Lastly, as sponsors navigate a more challenging fundraising environment and/or LPs do not receive distributions that could funnel into new or follow-on investments, these facilities may help align the interests between sponsors and LPs, while bridging potential capital gaps. However, lines of credit are by no means risk-free and, beyond collateral risks, can negatively affect fund economics. This article will explore the benefits and pitfalls of subscription facilities and NAV facilities from the perspectives of both sponsors and LPs.
What Are Subscription Facilities?
Subscription facilities are credit lines—typically of short repayment term—secured by unfunded capital commitments from LPs. Credit line terms vary on a case-by-case basis and are negotiated between sponsors and lenders, but, in general, these credit lines are usually not intended for use as permanent leverage or early capital distributions to LPs. Instead, they are meant to act as a bridge financing tool, providing liquidity until capital is called from and delivered by LPs, thereby helping to ensure that sponsors can smoothly cover expenses or make investments without having to rely on immediate LP contributions.
For sponsors, subscription facilities can reduce the administrative burden by (x) consolidating capital calls into larger, less frequent calls for each LP and (y) enhancing the facilitation of time-sensitive transactions that may require quick deployment of capital. In some cases, subscription facilities may delay the accrual of preferred return until the date on which capital is called from LPs and therefore create a potential cost-saving opportunity for sponsors by arbitraging between the rate of preferred return and the cost of borrowing.[1] More importantly, by being able to make capital calls at a later date, some sponsors have used this time preference as a way to shorten the holding period of LP contributions to slightly increase the internal rate of return (IRR).
For LPs, subscription facilities can also help (x) reduce the administrative burden of responding to frequent capital calls and (y) plan cash management, by providing extra time to arrange for the delivery of funds. However, delayed capital calls can also expose LPs to price and/or reinvestment risks, depending on their overall portfolio management,[2] especially if preferred return does not accrue from the date on which the facility is drawn and on which uncalled LP capital contributions are put at risk.[3] And for LPs that prefer to avoid any unexpectedly large—even though less frequent—capital calls, the benefits of call consolidation are less appealing and can instead complicate such LPs’ cash management. Importantly, many LPs now recognize the impact of subscription facilities in elevating IRR, which in turn can tip the scale and trigger, under some fund documents, a higher rate of carried interest (or “super carry”, which is usually contingent upon achieving superior fund performance, typically measured by IRR). For this reason, LPs are increasingly circumspect of the use of subscription facilities, their potential impact on net IRR, and the methodology used for calculating net IRR.[4]
NAV facilities are credit lines backed by the value of a fund’s portfolio investments and are increasingly used by sponsors to support underperforming investments or offer partial exit distributions to LPs. Unlike subscription facilities, which are secured by unfunded capital commitments and require an evaluation of each LP’s creditworthiness, NAV facilities are tied to the cash flow and capital structure of the fund’s underlying assets that are being secured. For sponsors, NAV facilities create leverage, typically below the fund level, thereby allowing sponsors to allocate capital to portfolio companies as needed, service debt, make distributions to LPs, or, especially in today’s market, secure extra liquidity for secondary transactions—all potentially without breaching, or even being subject to, fund-level borrowing limitations. This flexibility can be valuable; however, it requires careful consideration, since many fund documents do not specifically address NAV facilities given their relatively recent adoption in the private fund finance landscape. As NAV facilities become more common, LPs may seek greater transparency from sponsors regarding a specific facility’s structure, its impact on the fund’s returns, as well as its long-term implications for both the fund and the LPs’ invested capital.
Traditionally, when a portfolio company has been de-levered and can take on additional debt but has not yet reached the target required for an exit, sponsors tend to avoid selling at a price that could negatively impact their expected IRR. In such cases, sponsors typically use the proceeds from the portfolio company’s dividend recapitalization to (x) return some equity to LPs as interim distributions and (y) increase distributions to paid-in capital (DPI). In recent years, however, NAV facilities backed by the entire private fund portfolio or select portfolio companies are increasingly utilized to achieve the same outcome. Compared to dividend recapitalization of a single portfolio company, portfolio financing is generally more efficient in terms of due diligence, while generating sizeable proceeds and avoiding direct debt obligations on any single portfolio company. Importantly, if used to provide partial, early exits to LPs—much like dividend recapitalization—NAV facilities can also improve key fund metrics like DPI and IRR, which can help the sponsor market subsequent funds.
For LPs, NAV facilities can ease the burden of having to fund follow-on investments while, as described above, benefitting from receiving early distributions that can be reinvested. However, some LPs have raised concerns regarding the use of NAV facilities. Specifically, since NAV facilities are relatively new but are often utilized by funds that are several years into their lifecycle, such funds’ offering and governing documents frequently do not explicitly address the use of NAV facilities. As a result, sponsors may secure NAV facilities without being bound by typical fund-level borrowing limitations, as these loans are often issued through one or more SPVs sitting between the fund and its portfolio companies. This can lead to situations in which LPs are not even aware that NAV facilities have been drawn. Additionally, while many LPs appreciate these early distributions, some do not,[5] sometimes pejoratively referring to them as “synthetic distributions”, especially since they are usually recallable. As a result, LPs tend to be particularly cautious about reinvesting these distributions back into the same sponsor’s subsequent fund due to concerns regarding overexposure. Furthermore, NAV facilities can be costly given the relatively illiquid nature of the private equity assets; LPs may be opposed to paying interest on their distributions, regardless of how early such distributions were received.
Conclusion
Subscription facilities and NAV facilities offer private fund sponsors valuable flexibility to navigate cash flow needs and optimize capital deployment across a fund’s lifecycle. These credit lines can benefit both sponsors and LPs. Subscription facilities help streamline capital calls and facilitate cash management, while NAV facilities help provide liquidity solutions that can support portfolio companies and offer interim distributions to LPs. However, the evolving landscape of fund finance also requires a careful balancing of the benefits and risks of such facilities, particularly from the LPs’ perspective. In recent years, LPs have become increasingly attentive to how these facilities (x) impact fund economics (e.g., IRR and DPI) and (y) impact cash flow timing and fund expenses.
Ultimately, while subscription facilities and NAV facilities can provide certain advantages, sponsors must navigate LPs’ concerns transparently, addressing potential drawbacks. By doing so, sponsors can build trust and ensure that such facilities are used in a way that helps to align the long-term interests of both sides, fosters operational efficiency, and is consistent with LPs’ financial expectations. As the use of such facilities continues to grow, both sponsors and LPs stand to benefit from greater awareness and clarity around their application.
[1] However, in the current high-interest rate environment with tighter spreads, the primary value of subscription facilities has shifted toward reducing the administrative burdens of capital calls.
[2] The benefits of a delayed capital call depend on how an LP manages its overall portfolio. For example, an LP faces 1) price risk if the value of its underlying investments declines during the delay; and 2) reinvestment risk if it cannot generate returns at the rate of preferred return during the delay.
[3] The Institutional Limited Partners Association, in 2017, recommended that preferred return be calculated from the date the credit facility is drawn. In that context, if preferred return accrues from the date the facility is drawn, LPs can take advantage of such accrual in addition to, theoretically, a risk-free rate of return until the capital is called.
[4] Although IRR remains a key performance metric, the private equity industry—particularly from the LPs’ perspective—has increasingly shifted toward distributions to paid-in capital (DPI), which is agnostic to the time value of money, as a more meaningful measure of performance.
[5] The decision to draw NAV facilities may be subject to the approval of a majority or other specified percentage in interest of the LPs, or the approval of a limited partner advisory committee (LPAC), in which case smaller LPs would not have discretion over whether or not to receive early distributions.
