By Ryan B. Leverone

Partner | Corporate & Finance

In a previous issue of Fund Finance Friday, NAV loans were described as the Swiss Army knife of the fund finance market—and for good reason. Unlike other types of financing (like portfolio company-level loans or subscription facilities), NAV loans can cover a broad (and constantly evolving) range of structures and asset classes in the market. Their versatility makes it so that sponsors and lenders can tailor the product to solve for any number of issues and situations.

For the uninitiated, NAV loans are fund-level credit facilities underwritten primarily to the net asset value of a fund’s investment portfolio. Unlike portfolio company-level loans (which are typically supported by the operating assets of a portfolio company) or subscription facilities (which are typically supported by fund-level investor commitments and capital call proceeds), NAV loans rely on the value and cash flows of portfolio assets.

One structure we’ve seen more of recently in NAV facilities is the use of direct, asset-level security over a fund’s portfolio assets. For example, if a fund’s assets consist of a suite of debt and equity stakes held by a holding vehicle, that holding vehicle would grant a direct lien on those assets in favor of the lender. Lenders that take direct, asset-level security can sometimes offer higher loan-to-value ratios or lower pricing than they might for a negative pledge (where security is typically just taken over the fund’s collection accounts, and otherwise the fund generally covenants not to pledge the assets to anyone else) or indirect pledge (where security is taken over the equity of holding vehicles that hold the portfolio assets) structure. Generally, this is due to the fact that taking good asset-level security means fewer steps are required for a lender to realize on the value of the assets in a foreclosure situation, and correspondingly higher expected recovery.

The flip side of that value proposition is that taking direct, asset-level security requires close diligence of the assets to ensure that the lender can actually obtain a direct pledge in the relevant jurisdiction and, if it comes to it, foreclose on them. Outcomes for the lender depend on, among other things, the enforceability of the security on, and the salability and liquidity of, the relevant assets.

Below we set out some of the key considerations:

1. Pledge and Transfer Restrictions

1. The underlying documentation governing the fund’s assets will very often require some level of consent from the relevant sponsor, general partner, manager, etc. in order for the fund to grant a security interest in the asset or transfer it to a third party (e.g., their lender in a foreclosure situation). Getting those consents can be a time-consuming process, and since third parties are often involved success isn’t guaranteed. Side letters, change-of-control restrictions and other approval requirements can also affect the timing and scope of any consent. Sponsors at the asset-level can be hesitant to grant such consents, particularly in favor of an unknown transferee. Even when an asset-level sponsor agrees to provide consent, they may seek to impose limitations or ask for additional things (e.g., confidentiality restrictions).
2. The contracts governing assets can also include rights for other investors to participate in any transfer or sale (e.g., rights of first refusal, tag-alongs, etc.), which could complicate a foreclosure effort.
3. Often there are specified eligibility requirements that any potential transferee would need to meet in order to effect a transfer—e.g., not being included on an ineligible transferee list maintained by the sponsor, etc.
4. Particularly for equity assets, there may also be legal restrictions on transfers (e.g., securities laws) that need to be complied with.

2. Jurisdictional Considerations

The jurisdiction in which a debtor is organized or portfolio asset is situated (which for intangible assets, with some important exceptions, is usually determined by the governing law of the contract that created the portfolio asset) will generally determine which jurisdiction(s) a lender needs to take security in. If a portfolio includes non-U.S. debtors or assets, local counsel needs to be engaged to address potential issues and ensure compliance with applicable law. Some non-U.S. jurisdictions may not easily provide for a pledge on certain assets and may instead require an assignment or other transfer of the interest.

3. Perfection and Priority Mechanics

Subject to the jurisdictional considerations above, even if the debtor is organized, and the portfolio assets are situated, in a U.S. jurisdiction, there are steps a lender may or may not need to take to ensure it is perfected and has priority in a given asset depending on the characteristics of that asset. For example, if a portfolio asset is securities held in a securities account, a lender can perfect its security interest by filing a financing statement, but this method of perfection is inferior to taking control of the securities account (typically by way of a securities account control agreement)—if a lender perfects in a securities account only by filing, the door is left open for a competing creditor to supersede its priority by taking control of the account.

Similarly, if a portfolio asset is equity interests in an entity whose organizational documents require the issuance of physical certificates evidencing ownership, a lender should take physical possession of that certificated equity—taking possession of certificated equity prevents a competing creditor from doing so and obtaining higher priority relative to the lender. Conducting the necessary analysis of the assets to ensure a lender is perfected and has priority in a fund’s portfolio assets often requires detailed diligence.

If these points aren’t considered and addressed, a lender’s enforcement rights may be impaired, the pledge might be invalid or the realization on the value of the assets might be limited.

Concluding Thoughts

Taking good direct, asset-level security can get complicated, but a solid collateral package is often worth the trouble. In addition to securing the lender’s priority in a bankruptcy situation, it also makes it much easier for a lender to realize on the value of the assets in an out-of-court enforcement scenario since the work of making sure the lender can foreclose has been frontloaded. Despite the added complexity, we expect interest among lenders and borrowers in direct, asset-level pledges in NAV facilities to continue to increase.