(Bloomberg) -- Private equity’s recent splurge of piling ever more debt onto already highly leveraged bets has sparked fears about financial-system risks. Banks, however, are positioning themselves to take advantage.
As buyout firms have struggled to sell companies in a difficult M&A market, many have turned to “net asset value” loans, where they borrow money from specialist funds or banks secured against a portfolio of their holdings — often at very high interest rates. It’s been a controversial way to avoid booking losses on asset sales while hoping for a better environment for making deals.
Now, a corner of the banking industry is being tapped to help finance funds that do NAV lending, a sign of the growing maturity of this type of financial engineering. Banks such as Nomura Holdings Inc., Goldman Sachs Group Inc. and JPMorgan Chase & Co. are among a group of lenders willing to offer so-called fund-level or portfolio finance, according to people familiar with the matter. Barings, an asset manager, is also active, the same people say.
Spokespeople at the banks and for Barings declined to comment.
NAV-fund owners have offered up everything from single loans in their holdings to entire portfolios as collateral to secure financing, according to market participants, partially adding another layer of leverage to an increasingly popular pocket of the $8.2 trillion buyout industry. They can borrow from an individual bank or syndicate of lenders.
“Fund financings are varied and can come in many different guises,” says Richard Fletcher, a partner at law firm Macfarlanes. “We’re able to make the structures bespoke.”
Some investors in private equity, and even some firms themselves, have complained that NAV lending is a form of financial engineering that can delay losses and encourage buyout groups to forget their core mission to improve companies. Regulators worry about unconstrained leverage creating systemic dangers. NAV lenders sometimes charge interest rates in the mid to high teens.
But for industry advisers, the expansion of the NAV financing ecosystem is explained in part by lenders not wanting to force buyout firms, with whom they have ties, to sell assets at the wrong time. Borrowers use the money to spend on their companies, or even to buy businesses, and sometimes to make payouts to their investors, known as limited partners.
“NAV is here to stay,” Fletcher says. “Especially where banks are concerned, there’s a significant amount of relationship involved in these fund-level deals. No one wants to be enforcing in this world.”
Fund Finance
This type of money-raising is part of a bigger booming market known as fund finance, which has taken off as private-capital firms keep ownership of companies for longer and their monetization of assets slows. Ares Management reckons fund finance is already a $1.2 trillion market, as firms hunt for alternative sources of cash. It estimates NAV facilities alone will double to roughly $300 billion in the next two years.
Other NAV-fund owners have issued complicated securitizations linked to the funds to bring in money. AlpInvest, part of Carlyle Group Inc., is one of a raft of firms — including HSBC Holdings Plc’s asset manager, Apollo Global Management and Ares — that have raised cash that can be used for NAV lending. And in its latest money-raising issue it has used investor stakes in a NAV fund as collateral.
AlpInvest’s new instrument is a $1 billion collateralized fund obligation, a type of derivative where LP interests in a group of funds are pooled together to back the security. Investor stakes in AlpInvest Strategic Portfolio Finance Fund 2, a NAV lender, make up one of the assets backing the CFO. Coupons on the secured notes range from 7.371% to 12.881%.
Despite such high borrowing costs, market participants say the sale of this type of instrument is attractive to firms like AlpInvest because it’s still a relatively cheap cost of capital compared to what they can make on NAV loans, or from the other types of private equity funds that may also underly the CFO.
Like the buyout firms who borrow from NAV funds, raising cash this way can be used to make payouts to long-standing investors, although CFOs are more often tapped to bring in new money. The securities are rated by credit-rating companies, giving more tightly regulated investors such as insurers access to a corner of private markets that’s usually off limits.
Still, these are largely uncharted waters. “It’s relatively uncommon to have CFOs backed by NAV funds,” says Greg Fayvilevich, a managing director at Fitch Ratings. “That’s primarily because NAV funds are relatively new.”
But some argue most of the risk in CFO deals is to equity owners, not lenders.
“This isn’t an area I think is going to blow up,” says John Cocke, deputy chief investment officer for credit at Corbin Capital Partners. “It’s just a bit of a Frankenstein structured-finance solution employed to enhance returns. It’s a viable way of going about it, but it bears more risk to the equity investors.”
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