Private Markets 360° | Episode 32: The Power of NAV Financing

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Chris Sparenberg [00:00:00]:
Welcome to Private Markets 360, your insider's guide to the world of private investments. Today we're joined by Peter Hutton, head of NAV Financing and Arcmont Asset Management, one of Europe's largest private credit firms. With 38 billion euros in assets under management, Peter brings a wealth of expertise to the table. Having spent seven years at aimco where he played a pivotal role in developing the NAV finance strategy from the ground up. His extensive experience in the private debt team has equipped him with unique insights into the intricacies of NAV financing. Join us as we delve into Peter's journey, the fundamentals of NAV financing and the future trends that are set to reshape the investment landscape. Peter, welcome to Private Markets360. It's a pleasure to have you on today.

Chris Sparenberg [00:00:43]:
How are you?

Peter Hutton [00:00:45]:
Very well, thank you. Great to be here and looking forward to the discussion.

Jocelyn Lewis [00:00:48]:
We are too, Peter, thrilled to have you. So let's kick it off by learning about your career journey. What led you to specialize in NAV financing and what has your experience been like at arcmont?

Peter Hutton [00:01:02]:
Good question. So I started my career actually at Lazard doing M and A, working on both equity and debt capital markets opportunities as well and then really moved to AIMCO to build the global private debt business there. So $180 billion Canadian asset manager and pension fund and it was the opportunity to really grow that business from at the time was kind of under 500 million by the end to over 8 billion. Building out direct lending, junior capital structured credit, CLO at MES and MSRT and then ultimately NAV financing. So I started investing in nav financing in 2017, 2018 and from a broad private credit perspective there was lots of like this is investment grade risk at direct lending returns, low volatility return profile, floating rates, hedge for inflation, highly diversified risk with a lot of structural protections and benefiting from the franchise risk of the private equity sponsors with no single source of repayment and so generating an attractive return premium for illiquidity, complexity and a large supply demand imbalance. So these privately negotiated bilateral transactions is really where you can find very attractive returns. And so when it comes to arcmont, you know, the big theme in the private markets today is consolidation not only via M and A, but also on a day to day basis consolidation of relationships and financing providers. And so the objective to build a one stop shop where lenders have typically built up 10 to 15 year relationships with sponsors, executed multiple transactions together and you've built up that trust reputation.

Peter Hutton [00:02:57]:
And so the Ability to leverage that trust, to offer multiple new products is really a win win scenario in our view. And so NAV financing is a natural extension of that. And indeed our sponsor relationships were asking us to launch a product in a space. So I came on board last year to launch that as a dedicated strategy with a dedicated team.

Chris Sparenberg [00:03:19]:
That's a great background. Let's jump into understanding NAV financing for those in our audience who are less familiar with it. Could you walk us through what NAV financing is, how it operates and kind of the role that it plays in private markets?

Peter Hutton [00:03:32]:
Yeah, absolutely. Our position in private credit is firstly 100% focused on private equity. So we have a global mandate leveraging ARC wants relationships in Europe and Churchill's private equity funder funds relationships in the us. So we know the sponsors, we've been partnering with them for 15 years and we've executed billions of euros of direct lending transactions and we do that each year. And now we can provide now financing solutions. But in addition to knowing the sponsors, we also know their assets and so we can lend against those assets which we can underwrite on the direct lending aside. So typically diversify portfolios of EBITDA positive cash flow generating mid market assets which we've typically already diligence or lent to a high percentage of these of their underlying assets and portfolios already. So that enables us to get a really granular view of the nav, which leads to a more accurate cash flow sweep repayment profile, more accurate pricing per unit of risk and ultimately more flexible structures versus the market.

Peter Hutton [00:04:43]:
And so with a strong credit discipline and restructuring expertise. We've been doing this for sort of 15 years. Instruction complex instruments for sponsors. It's really an extension of that given the Nuveen Tia relationship. Tia Fortune 500 company with 1.3 trillion A founded by Andrew Carnegie over a hundred years ago, essentially as now part of Nuveen Private Capital, one of Nuveen's affiliates. The way you should think about Arpmont, especially from a NAV financing perspective, is really one half of Nuveen Private Capital, which is an approximately $80 billion asset manager, 100% focused on mid market private capital solutions. And so your question of kind of how should we think about NAV financing and what is it? From taking a step back, I would say there are three main types of NAV financing that we focus on. The first is fund financing.

Peter Hutton [00:05:41]:
So this is where you're lending to a specific sponsors fund with a known number of underlying portfolio companies. There's diversified mature portfolios of EBITDA positive cash regenerating assets. And typically you are lending where the use of proceeds is for the most part to generate additional value creation through bolt on M and A. The second main bucket of NAV financing is GP financing. So this is lesser kind of hybrid credit asset backed lend such as fund financing. This is much more of a cash flow based lend at the GP level. And the cash flows can come either from management fees from GP commitment distributions and or carry interest across one or a number of funds. And so the most common use case I would say at the moment we're seeing is GP commitment financing where sponsors may not have sold a number of the previous assets in their funds, but they have deployed a lot and they have started the fundraising cycle.

Peter Hutton [00:06:48]:
And so not only do they want to increase their GP commitment from maybe 1% or 2% up to 3%, 4%, 5%, but of course it's significantly enhances the alignment of interest with the LPs which is extremely important. And then the third bucket of NAV financing is LP financing. So this is not only providing liquidity against LP commitments in private equity funds, but also this is LP commitment financing. So if LPs are facing any number of liquidity issues that still find investing in private equity to be very attractive, then you know we are there to help them facilitate that. So those are the sort of three areas in the whole of NAV financing.

Jocelyn Lewis [00:07:33]:
Peter, thank you so much for that clear breakdown. And it's really interesting to hear those different use cases within NAV financing, from the fund level strategies to GP and LP solutions really paints the picture of that broad ecosystem for NAV financing. I guess we've seen a structural shift over the past couple of decades with sponsors increasingly seeking more flexible liquidity solutions. And NAV financing appears to be part of that evolution. Can you comment on what's driving the increasing adoption of NAV financing in today's environment?

Peter Hutton [00:08:19]:
Yeah, it's very interesting because private markets have significant grown and evolved significantly over the last few decades and that increasing complexity has driven really a lack of capital and a lack of complex financing solutions for increasingly complex private markets providers. So of course GP financing we've mentioned for example non dilutive pref as an alternative to a minority sale or LP financing to release liquidity to help finance fundraising. But I think the most clear example of this is really on the fund financing side. So fund financing, which is vast majority of the time used to finance additional value creation, additional bolt on M and A. And this is interesting because over the last 10 years in private equity, 47% of all value creation was driven by multiple expansion. But recently, given the change in interest rates, we expect that over the next 10 years the percentage of value creation that will come from multiple expansion to be significantly lower. So multiple expansion can no longer be a driver of the same returns, but at the same time, M and A as a value creation tool has become increasingly popular. And today almost every sponsor enacts some kind of value creation through M and A buy and build in order to increase their returns.

Peter Hutton [00:09:45]:
But in our view, traditional asset level financing is relatively constraining on those returns. So if you are going to execute your buy and build plan, you've got kind of three traditional options, you've got additional equity, which obviously is very expensive and in relatively short supply. Secondly, you've got additional senior debt, which of course is limited by covenants and creates an additional cash burden on the underlying asset. And thirdly, you've got additional junior debt, which again is very expensive and of course maybe at an attached attach point in the capital structure, which could be uncomfortable to many sponsors downturn. And so in that context, NAV financing really emerges as a flexible finance law, which number one, is far more flexible from a timing perspective. And you can typically execute a fund financing NAV loan between years three and seven of the fund's life. Secondly, it's low ltv, but the collateral is the entire fund. So the quantum that you can raise is significantly larger than any traditional asset financing can do.

Peter Hutton [00:10:56]:
There's also zero distraction to management teams and there's also pick interest, so there's no additional cash burden to any of the underlying companies. And so bottom line, in our view, NAV financing doesn't replace any of those three other asset level financings that I've just mentioned, far from it. But it does enable you to target much larger M and A opportunities, transformational M and A opportunities previously not possible with traditional asset level financing. Plus the benefit of generating significant additional amounts of equity at the fund level, but at a debt cost of capital is also highly accretive to sponsor returns. And so how do we think about this from an asset class perspective? In our view, NAV financing is following the same adoption trends as other similar asset classes such as direct lending, secondaries, subscription line facilities. And so according to our research, which shows that the average increase to net IRRs of 100 to 175 basis points with using a NAV financing loan, that could be the difference between first or second quartile. And in our view, LPs are increasingly focused on that Gross to net spread and waking up to the realization that actually a fund investment is more than just a series of asset level investments. So in our view, NAV will become ubiquitous, just like subscription lines.

Peter Hutton [00:12:26]:
And if LPs are comfortable with sub lines, in other words, other fund level lending, and they're also comfortable with the continuation funds as a way to manage those conflicts inherent in continuation funds, then NAV financing just requires more education as a product, which is natural as a new product, but ultimately that adoption will continue to increase.

Jocelyn Lewis [00:12:48]:
That's a real great overview of how NAV financing can help to unlock value and provide flexibility for both sponsors and LPs. And it's clear that extended hold periods can offer a meaningful upside when managed strategically. So let's shift to the risk return dynamics. And from the LP's perspective, how does fund level leverage and high asset level leverage affect cash flows and default risk?

Peter Hutton [00:13:24]:
So clearly, if the sponsor does nothing from a leverage perspective, then that is leverage neutral. So the real question is if they want to generate additional capital in order to execute on value accretive M and A, what is the best form of leverage? And so the question really is down to the sponsor, which is what would you prefer? Would you prefer to invest additional equity, which is expensive, potentially dilutive? Would you prefer to invest with additional senior debt, again which could be expensive and also has an additional cash burden on underlying company? Would you prefer to invest additional junior debt, obviously much more expensive and at a potentially uncomfortable LTV versus ENAM financing, which is a low LTV and potentially more value accretive. And again, these are not mutually exclusive. But from a default risk perspective, NAV financing, given this is fund level lending or lending to an SPV below the fund and therefore junior to the asset level senior debt, there is little to no impact on default risk of the underlying assets versus additional asset leverage, which naturally does increase default risk due to the additional cash burden and additional debt component of the capital structure. So in our view, the probability of default of a NAV loan is very low, given the low ltv, the diversification of the underlying collateral, the fact that you can diligence that underlying collateral, the structural protections and the franchise risk. But in reality, sponsors will use both asset level financing and fund level financing for a flexible array of solutions. And so in the long term, our view is that lenders really need to have a comprehensive and holistic view of the sponsor, both from a fund level perspective and at an asset level perspective, to be speaking the same language. And ultimately the fates of the sponsors, the LPs and the NAV lenders are closely tied.

Peter Hutton [00:15:33]:
So that alignment of interest is extremely important. But the reality is given all of these benefits that we've mentioned about diversification and the ability to diligently underlying portfolio the structural protections, we view a NAV financing transaction as a win win for all parties.

Chris Sparenberg [00:15:51]:
Certainly seems like this is becoming more prevalent and certainly that investors are starting to embrace it. What other major trends are you seeing that shape the future of NAV financing? And how are those trends changing the dynamic between sponsors, investors and financing partners?

Peter Hutton [00:16:07]:
Yes, there are a number of I think increasingly important themes emerging. I think the first is that strategic relationships really do count. And if you are only able to offer one product versus a one stop shop who can offer multiple products, we see that leads to much stickier relationships which are the foundation for long term success. Secondly, the requirement of CFOs, capital markets teams and managing partners of private equity sponsors to at least be familiar and fluent with a number of these different financing tools is also not no longer going to be a luxury but is going to be a requirement. And so you can see that not only in the focus of gross to net spread, but you can also see that with the proliferation of sponsors who have been educated on things like continuation funds and are continuing to do continuation funds which not only satisfies their own objectives but also their LP objectives as well. And so we see that NAV financing will be another example of that. Another important theme, especially around NAV financing is around greater alignment of the competition fund. I think over the last 10 to 15 years, given that the development of these bespoke financing solutions has often outpaced the the development of the LPAs to allow for them.

Peter Hutton [00:17:32]:
In our view, there will be more consistency of fund structures and the key terms in the LPAs that will allow for NAV financing on the fund level, leverage and also more adherence to the LMA guidelines as well. And then lastly is I think greater transparency and communication with LPs. Education is the key, you know, as it was with subscription line facilities. But in our view these are going to be increasingly important financing tools. And therefore it's extremely important that education is correct for all stakeholders, including with the LPs.

Jocelyn Lewis [00:18:14]:
Peter, those are some real powerful shifts, especially the move towards greater transparency and alignment across stakeholders. And it's clear that NAV financing sounds no longer like just a tool, but more of a strategic in fund management. So when you mention greater transparency and alignment, how are these trends reshaping how sponsors engage with both investors and their financing Partners in practice.

Peter Hutton [00:18:48]:
Look, the reality is that most lenders in financing in the mid market of borrowed equity, both Europe and the us, the vast majority, are acting in a very transparent, open way and always insist that the sponsors should go and get LP approval, either implicit or explicit. And so sponsors themselves are generally taking a much more proactive role in educating Both their own LPs and folks internally about the options available for NAT financing. So for example, if the capital markets head or the CFO is familiar with NAV financing, but the deal teams don't necessarily know that now they can go out there and execute on that attractive M and A opportunity, then there's a disconnect there. So internal teams and deal teams also need to be aware of these facilities as well as the CFOs and heads of capital markets as well as their own lp. So I think education across the board is as much more of an important theme. Therefore, as sponsors align their own fund documentation, we believe it will build more trust and consistency across stakeholders. And again, billions of dollars of NAV financing transactions are executed every year, often with the most sophisticated sponsors who have the most sophisticated LP base. So we know that there is a strong use case when NAV has a is used for the quote right reasons, end quote.

Peter Hutton [00:20:13]:
But lenders are becoming increasingly more sophisticated and flexible in what they can offer to sponsors. So we see that sponsors are offering asking their own fund counsel to engage earlier when they're setting up their new LPAs and fund structures to allow for some of these more complex financing arrangements. And so really the dynamic is shifting from kind of transactional relationships to much more strategic relationships where sponsors, LPs and lenders are collaborating much more closely to optimize those outcomes.

Jocelyn Lewis [00:20:48]:
Peter, thank you so much for joining us. What a fantastic episode. And thank you all for listening to this episode of Private Markets360 featuring Peter Hutton, head of NAV Financing at Arcmont Asset Management. Peter shared his journey through the private credit space and offered sharp insights into the evolving role of NAV financing. We unpacked how NAV financing is reshaping liquidity and flexibility for sponsors and explored key trends driving its future from fund level strategy shifts to greater transparency and alignment across stakeholders. We appreciate you tuning in and hope you found this discussion both informative and and inspiring. Don't forget to subscribe to Private Markets 360 for more expert perspectives and deep dives into the forces shaping private investments. Until next time.