(Bloomberg) -- Private equity firms should alert investors before they borrow against their funds’ assets — especially when using so-called net-asset-value loans to juice returns, according to new guidelines from a trade group for such investors.
The Institutional Limited Partners Association issued the guidelines Thursday on NAV loans after much debate about their use amid a prolonged deal drought that has dampened distributions. While some firms contend NAV loans can help them raise cash when times are tight, certain investors perceive them as risky financial engineering that can imperil portfolio companies.
In particular, investors — known as limited partners — fret that any distributions they receive from a NAV-based facility could later be recalled to help pay down the loan.
That could disrupt the limited partner’s ability to invest in other funds or even make payments to its beneficiaries, according to ILPA, which represents pension funds, endowments and other private equity investors. Recalls could also interfere with cash-flow planning.
“We continue to hear from our member LPs that NAV-based facilities are being implemented in ways that leave them in the dark with respect to associated costs and risks,” Jennifer Choi, the group’s chief executive officer, said in a statement.
Teacher Retirement System of Texas, the state’s largest public pension, has been pushing back on its managers’ use of NAV loans without investor consent and helped devise the trade group’s guidelines, according to people familiar with the matter.
It has also raised questions about continuation funds, another tool that private equity firms are increasingly using to cope with under-achieving assets, said the people, who asked not be identified discussing confidential information.
A spokesperson for Texas Teachers declined to comment.
The pension fund manages $202 billion of assets and recently decided to shift almost $10 billion out of private equity investments because of dwindling returns.
The trade group said firms should get approval from the limited partner advisory committee for the use of NAV loans when limited-partner agreements are silent on the issue, and that they should always get permission if the loans are being used for distributions.
Investors are also frustrated when they need to pay interest expenses on recallable distributions.
Moreover, the trade group said NAV loans can create “perverse incentives” for firms to bolster headline performance figures and that the lack of transparency impedes investors’ ability to monitor fund performance. The guidelines recommend that investors ask whether a distribution can be recalled and that private equity firms disclose the rationale for tapping a NAV loan.
--With assistance from Dawn Lim.
(Updates with Texas Teachers starting in sixth paragraph.)
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