This is the second of three blog posts based on our recent white paper, available at the link above.

Net asset value (NAV) financing, a type of lending to investment funds and asset managers in which the cash flows and the value of the fund’s underlying assets serve as collateral for the loan, are typically used for acquisition financing, debt refinancing, or accelerating distributions to limited partners (LPs).

• Re-Investment: General partners (GPs) can use NAV loans to support existing portfolio companies or acquire new assets, aiming to increase equity value.
• Refinancing: Refinancing NAV loans can replace asset-level debt with a lower cost of capital by leveraging cross-collateralization. This approach can bridge capital gaps during periods of macroeconomic or company-specific challenges.
• Distribution: GPs may use NAV loans to accelerate distributions to LPs, boosting distributions to paid-in capital (DPI) through portfolio recapitalization rather than asset sales. These transactions, often contentious, aim to enhance DPI ahead of fundraising efforts but may burden LPs with implicit costs, including disadvantaging LPs if the payouts do not lower the management fee base.

Re-investment and refinancing use cases are generally called “money-in” transactions in which the GP seeks to build value by facilitating growth. However, NAV loans that only facilitate distributions are considered “money-out” transactions. The use of NAV financing for “money-in” transactions is viewed positively by LPs. In contrast, many LPs have a negative disposition toward “money-out” transactions, and we would concur.

Risks and Challenges of NAV Loans

While NAV financing offers flexibility, it also carries risks. Cross-collateralization can mitigate lender risk and reduce borrowing costs, but it also creates interconnected vulnerabilities. Stress in one asset can cascade through the portfolio, jeopardizing all collateralized assets. In such scenarios, lenders might demand additional collateral, triggering fire sales or redirecting portfolio cash flows to service debt. NAV lenders typically have first claim on the cash flows and underlying assets over existing senior secured loans. Furthermore, in the event of default, GPs may have to liquidate high-performing or high-potential assets, potentially eroding returns for LPs.

Transparency and communication gaps around NAV loans can also strain GP-LP relationships. When used merely to create artificial liquidity or enhance DPI without a clear value-creation strategy (“money-out” transactions), NAV loans may justifiably face skepticism from LPs. Rational use cases, such as reinvesting to grow portfolio value, require thorough communication and alignment to maintain trust and equity among stakeholders.

Other considerations around “money-out” transactions are that they complicate the fund structure and may disadvantage LPs if the payouts do not reduce the management fee base. Additionally, it is common for such distributions to be recallable. In a worst-case scenario, if the NAV loan breaches its covenant—typically tied to the LTV ratio—GPs may need to recall distributions to repay the facility. Furthermore, “money-out” transactions challenge LPs to assess the quality of the DPI, raising questions about how much of the GP carry is being accelerated by an artificial rather than a conventional exit event.

Do LPs Have Any Choice or Influence in the Matter?

GPs have broad discretion in how they borrow and finance acquisitions. Fund legal documentation was often either silent or had vague provisions on NAV loans. Newer fund documents have incorporated specific provisions regarding NAV lending, including explicit permission for NAV financings, transparency requirements, leverage guidelines, and a process for limited partner advisory committee (LPAC) approval.

That said, disclosure remains uneven, with no market standard. We see this as a due diligence opportunity for LPs to probe GPs on how aggressively they intend to use these facilities and how receptive they will be to input.

To bridge the communication gap, the Institutional Limited Partners Association (ILPA) released guidance in 2024 on improving GP transparency, enhancing governance, and guiding better LP engagement on NAV loans. First, the association recommends that GPs use the term “NAV-based facility” in limited partnership agreements (LPAs) to ensure clarity. If an NAV-based facility is permitted in the agreement, ILPA advises GPs to inform the LPAC of the intent and rationale for any “money-in” transactions. For “money-out” transactions, ILPA recommends that general partners formally engage and seek LPAC approval.

ILPA recommends that NAV-based facilities be included in the fund’s leverage calculation, and outlines 12 key items that should be disclosed, including the use of proceeds, the rationale for using the NAV facility compared to other loan alternatives, the size of the facility, LTV ratio, loan tenor, interest rate, collateral, and covenants. ILPA advises LPs to ask several key questions, such as whether the NAV facility used for distributions reduces the management fee base or if the distribution is recallable.