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How Private Equity Leads to Value

It’s important to clarify what happens when a private equity fund acquires a company, creating attractive value for investors. The private equity fund will already have a concrete plan to increase the worth of the investment. Their strategy could include a dramatic cost cut, restructuring, or any other steps the existing management team may not have implemented. Extensive operational or management changes are more likely if the private equity owners have a limited time to add value before exiting an investment.

Private equity firms may also have the necessary expertise missing in the current management. It may support the company in developing a market strategy, adopting new technology, or accessing additional markets. Sometimes, they replace the incumbent management team or retain managers to implement an agreed-upon plan.

The acquired company can also make crucial operational and financial changes without the pressure of meeting analysts' earnings estimates. Additionally, they do not need to cater to the preferences of public shareholders every quarter. Private equity ownership may enable long-term management planning, provided it aligns with the owners’ objective of maximizing the return on investment.

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Modeling Private Equity Funds

Decision-making in private equity (PE) usually happens through financial modeling, which traces the trajectory from investment to exit. Private equity modeling has important practical applications. PE institutions and venture capital firms leverage these models to assess how viable a business is, enabling them to identify the risks of a potential investment.

Financial models also aid in evaluating the impact of management decisions and estimating possible returns for investors. The purpose of PE models transcends the initial cash outlay up to the period after the investment is made. Modeling provides a way to monitor an actively evolving business and provide insight into possible exit strategies.

Private equity acquisitions involve buying companies with significant debt, hence the name leveraged buyout (LBO)transactions. LBO modeling begins with constructing a three-statement financial forecast for the target company. A financial model helps estimate the value of the business with its current ownership structure before a buyout takes place.

Adjusting for the buyout is also necessary. This involves incorporating the new finance structure, including the impact of debt on the company’s cash flow arising from interest payments and debt servicing costs. This is where creating a debt schedule to outline the amount and maturity dates for all outstanding loans and debts is necessary.

Calculating the expected internal rate of return (IRR) of the private equity fund for the leveraged buyout deal is the final step that helps the fund manager determine if the target company is a viable investment for the fund.

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Subscription Credit Facilities Provide Cashflow Flexibility

Subscription credit facilities (SCF) provide credit that finances investments, fund-associated fees, and expenses. Combining various sources of cashflow within a single capital call, they offer a private market fund’s manager the flexibility to make fewer capital calls from the fund's limited partners. They can also defer initial capital calls until they need a major capital outlay.

Initially utilized in bridging capital calls, SFCs have evolved to meet various situations across sectors. Set up as a revolving credit line, set dollar amounts, or investors’ uncalled capital commitments define their limits. The sizing is typically between 15 to 40 percent of aggregate capital commitments, which enables the fund to flexibly borrow, repay, and reborrow substantial amounts of money.

Benefits of this approach, which provides capital on a committed or uncommitted basis, include boosting the internal rate of return (IRR) as the effective investment period shortens. SCF also provides predictability to cashflows, allowing managers more latitude in optimizing portfolio construction to reflect fast-evolving market dynamics.

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What Is Net Asset Value Financing?

In net asset value (NAV) financing, the loan size derives from the value of a private investment fund’s investment portfolio. NAV financing can offer significant returns and liquidity after an investor has exhausted other sources of capital. Due to the legal documents needed to detail transactions and the expertise to create and negotiate with them, only companies and banks use NAV financing. Individuals do not.

Earnings from asset sales, bank account pledges, and equity interest in the fund's assets serve as collateral. Most lenders narrow eligible borrowers by requiring a minimum number of assets or asset types in an investment portfolio.

NAV financing can benefit investors experiencing different degrees of success. If investors are performing poorly, they can rely on the liquidity of NAV financing to pay ongoing expenses or refinance preexisting debt. Conversely, investors can use NAV financing to make additional investments or insulate their assets against adverse economic conditions.

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Exploring Rated Note Structures in Private Equity

Rated note structures intended to appeal to insurance firms are still evolving and multiplying as private credit managers pursue their never-ending hunt for more assets under management (AUM) and diversify their capital sources. Richard Wheelahan, a member of Fund Finance Partners, spoke at the 2024 Fund Finance Association symposium in Miami about the latest developments in rated note structures with colleagues from Fried Frank, Maples, PJT Partners, Whitehorse Liquidity Partners, and Debevoise.

In rated note structures, a residual tranche of unrated equity capital supports one or more debt tranches. Insurance investors primarily benefit from the extended tenor that comes with the highest-rated note structures, as well as the bond risk-based capital treatment of the debt tranches. While senior secured, direct lending strategies are the primary use for rated note structures, many other credit strategies, such as royalties, non-traditional asset-based lending, and real estate debt, also involve using comparable strategies to optimize RBC (risk-based-capital).

While most rated note (and feeder) structures are sold "vertically," such as when an insurance company agrees to buy the fund's complete equity and debt capital structure, there is growing interest in setting up rated note structures "horizontally." Because they are not holding the relatively high RBC equity tranche, investors in insurance companies can, in these situations, access an even better RBC treatment. However, the residual, equity, or even sub-1 investment grade-rated tranches have been difficult to place on their own, and an effective market for those subordinated tranches has not emerged.

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2024 Private Equity Investment Trends

Private equity (PE) companies faced economic uncertainty throughout 2023 due to political instability and uncertain markets. One way they addressed these concerns was by prioritizing value creation. They adopted methods such as investing in human capital and enacting environmental, social, and governance (ESG) measures. Overall, value creation would insulate PE firms’ portfolio companies against adverse economic conditions.

Portfolio companies also began considering unorthodox exit paths after they obtained enough funding to reach self-sufficiency. Instead of going public or remaining with the PE firm, they would partner with an established corporation and negotiate an acquisition or merger. Assisting their portfolio companies during this process would strengthen PE firms’ preexisting assets rather than wasting money on assets that would not last.

Related trends changed the instruments PE companies use to allocate assets and protect them from plummeting in value. The most common action was creating liquidity with assets that maximized returns and minimized risk. Examples include money market funds (MMFs) and insured cash sweep (ICS) accounts.

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Enhancing Bank and Fund Sponsor Relationships

Building and maintaining fruitful relationships with banks is essential for achieving financial goals and fostering stability, especially for businesses. As banks and fund sponsors collaborate to drive success, clients can actively cultivate strong partnerships with their financial institutions.

Actively seek alignment in goals, risk appetites, and financial strategies with your lender. Engage in regular dialogue and collaboration sessions to ensure you and your lender are on the same page.

Establish clear communication channels with your bank/fund sponsor to foster transparency, trust, and accountability. Schedule regular meetings and feedback sessions to address concerns, exchange insights, and strengthen your relationship.

Work closely with your fund sponsor to develop customized services based on research that meet your specific needs and goals. By actively participating in the process, you showcase your commitment to success and gain a competitive edge in the market.

Similarly, collaborate with your lender to prioritize proactive risk assessment, mitigation, and monitoring. You could collectively develop risk management frameworks that preemptively address potential risks.

Embrace innovation as a shared endeavor with your bank to drive efficiency, performance, and growth. Explore opportunities to leverage cutting-edge technologies and market insights, positioning yourself as a forward-thinking partner.

Recognize the importance of investing in long-term relationships with your fund sponsor. Focus on building mutual respect and shared success over time, laying the foundation for enduring partnerships that withstand challenges and nurture trust and loyalty.

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Types of Fund Financing

In some cases, lenders offer alternative financing to private equity funds, such as fund finance or credit offers that supplement investor capital or help manage PE liquidity. The facilities available under fund facilities include subscription lines, net asset value (NAV), and leverage lines.

Subscription lines refer to credit financing offered against a future capital commitment of limited partners to the general partners. Thus, the general partner access returns faster and commits more to the PE fund. In this case, the primary security is the creditworthiness of the limited partners.

The second, the leverage lines, accesses the funds based on the value of the PE underlying holdings that serve as security. The leverage lines allow general partners to increase commitment to the fund. To reduce the risk to the lender and increase access to more funds, the PE commits the entire portfolio as collateral rather than single assets.

Lastly, NAV financing uses the cash flows from the various subsidiaries in the portfolio as collateral to access the funding. The goal is to increase access liquidity that is difficult to attain from the cash flow from the existing assets.

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Financial Derivatives Explained

A derivative allows an individual or a financial institution to benefit from the rise in the price of an asset, like stock from a certain firm, index fund, or even commodity, without paying the full price of that asset. To do so, they form a contract with a second party and agree on at least one asset, which will determine the derivative’s value, or even multiple assets of different types, called exotics. Depending on the derivative chosen, the parties may agree on a payout at a set date or after the asset experiences a rise or fall in price of a certain magnitude.

Completing a derivative contract presents benefits and risks different from trading assets on the open market because they can tailor their portfolio to their personal risk tolerance and account for fluctuating market conditions. Because an investor pays a small percentage of the asset’s price, they benefit massively from any gains. However, they lose all their money if the asset falls in price by an amount equal to or greater than the derivative’s value.

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The Ropes Talk Podcast

A leading business and institutional law firm, Ropes & Gray was The American Lawyer’s “Law Firm of the Year” in 2022. The firm serves many major companies and investment funds, handling complex business transactions and legal matters. Through its official podcast, Ropes Talk, Ropes & Gray reports and discusses the latest news in the world of law.

The podcast has covered court decisions and legislative and regulatory changes. Although Ropes & Gray doesn’t regularly release episodes of Ropes Talk, the firm generally produces between a half-dozen to a dozen episodes per month.

With episode titles that include “The Inevitable Rise of NAV Financing,” “A Word for Our Sponsors: Philanthropy & Giving Strategies by Fund Sponsors,” and “Non-binding Guidance: FDA’s Draft Guidance on Communication of Scientific Information on Unapproved Uses of Medical Products,” the podcast covers a broad range of topics. Different episodes of Ropes Talk feature various experts in their respective fields. For example, the September 2023 episode featured Fund Finance Partners Managing Director Anastasia Kaup.

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The Basics of NAV Financing

Funds of hedge funds have been utilizing net asset value (NAV) financing for more than 20 years to facilitate growth, but it is a relatively new and increasingly popular strategy among private equity firms and fund sponsors. NAV financing in the private equity industry increased 50 percent in deal volume and 40 percent in average transaction size from September 2021 to September 2022, indicating increased adoption of the strategy by managers and their portfolios.

Through NAV financing, private equity firms can provide capital to a fund by borrowing against the NAV of their combined assets. Despite uncertainties about how to price underlying assets in a NAV credit facility, firms are increasingly using this strategy to improve the value of their funds via acquisitions for portfolio companies. Moreover, traditional liquidity resources, including subscription lines of credit, have become less accessible, leading many firms to explore NAV financing.

When firms utilize NAV financing, money is repaid to the lender from the sale of companies or other cash flow from the firm's underlying diversified portfolio. NAV financing is a flexible and customizable product for fund managers and management companies as it can also be used to inject liquidity into portfolio companies, fill in fundraising gaps, and for distributions.

Anastasia Kaup, managing director of Fund Finance Partners, said her firm has noticed an “extraordinary increase in interest” in NAV financing, largely from private equity fund sponsors.

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Net Asset Value Markets Grow Among Traditional Lending Challenges

Guided by Zac Barnett, a Chicago lawyer, Fund Finance Partners (FFP), LLC, provides solutions in the net asset value (NAV) lending sphere. Working with various investors to secure funding, attorney Zac Barnett inhabits a sector traditionally led by commercial banks and has now ceded ground to private creditor lenders.

Once viewed as a way of supporting challenged assets, NAV financing is emerging as a standard way of boosting fund performance and as an asset class in its own right. As detailed in an August 2023 Private Funds CFO article, sponsors now focus on turnaround investments, opportunistic growth pathways, and utilizing NAV loans to manage capital efficiently. Reflecting this dynamic, NAV lending volume increased by 50 percent in 2022. With only around five percent of fund managers employing the product, some 90 percent of private equity funds have subscription facilities. There is significant room for industry expansion, and total NAV lending is forecast to rise from $25 billion to $110 billion by 2030.

One major impetus of this upward trend is accelerated growth within the NAV lending market. With rising interest rates, inflation, market volatility, and supply chain disruptions all playing a role, traditional financing routes are challenging to access. Financial watchers predict that as NAV loans move toward mainstream acceptance, they will “take their rightful place” as an established private credit asset class.

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Fund Finance Partners Executive Earns Diversity in Fund Finance Award

Attorney Zac Barnett is a managing director at Fund Finance Partners (FFP) in Chicago. In his role as lawyer, he delivers tailored debt capital solutions that help fund sponsors and investors raise required liquidity. In June 2023, attorney Zac Barnett's colleague Anastasia Kaup, also a managing director, earned the Fund Finance Association ‘s (FFA) Diversity in Fund Finance Award.

An inspiring industry success story, Kaup is known for her ability to help asset managers attain goals, while also providing advisory solutions across a range of asset classes. Formerly serving with an Am Law 100 ranked law firm, she maintained a fund finance practice before joining her current firm. The award reflects her tireless efforts to promote equity, diversity, and inclusion in the workplace.

Growing up in a marginalized community, Kaup spent time homeless before re-envisioning her life and gaining skills and qualifications in the legal sector. With FFP, she has been pivotal in organizing and sustaining “first of their kind” events that showcase the accomplishments of the LGBTQ+ and Hispanic/Latinx communities she is a member of. With an unflagging service-leadership orientation, Anastasia Kaup has positioned the company as a leader in these areas. Her insights on current markets were featured in a recent Private Funds CFO article.

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Fund Financing Moves toward Flexible, Collateral-Heavy NAV Lines

Guiding Fund Finance Partners, LLC (FFP), as an attorney and co-founder, lawyer Zac Barnett has experience organizing subscription and net asset value (NAV) lending that provides a flexible alternative to traditional bank financing. Actively involved in the industry, attorney Zac Barnett maintains an active watch on trends in the fund finance sphere.

As explored in a Private Funds CFO article, the collapse of Silicon Valley Bank, First Republic Bank, and Signature Bank, three of the largest subscription credit line providers, has had a profound impact on the overall banking system’s lending capacities. With base interest rates on the rise, the fund finance arena has shifted from aggressive deals to a flight to quality. Tier one financial institutions in the US and abroad are receiving numerous calls from fund sponsors looking to forge new relationships with counterparties that are stable and reliable. This makes reliable lenders extremely selective about who they take on and provide loans to.

Subscription NAV vehicles have stepped in to provide needed liquidity. Often secured through a collateral package, such vehicles deliver funds when other avenues of capital raising fail. The money can be used for a variety of purposes and provides leverage for business growth that is stable and moderated. Subscription NAV vehicles are currently utilized within about 90 percent of private equity funds, and are well on their way to becoming an established asset class in their own right.

Another emerging lending route is hybrid loan facilities, which consider both the fund’s investment portfolio and its investor capital commitments. These are particularly sought out by continuation funds, as they can bridge funding gaps related to differences in the sizes of various deals and available cashflow.

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“Sailing into Uncharted Waters” in Private Debt Investor

An Illinois lawyer with expertise in finance, Zac Barnett has been a leading attorney at Fund Finance Partners since cofounding this Chicago firm in 2019. He has a history of publicly sharing his insights both as an attorney and as an investment professional. In May of 2023, Zac Barnett’s opinions on the “the perfect storm” of current subscription financing appeared in the Private Debt Investor cover article “Sailing into Uncharted Waters.”

Written by Robin Blumenthal, Christopher Faille, and John Bakie, “Sailing into Uncharted Waters” evaluates the private debt landscape in the face of recent upheavals in the banking sector. In brief, the article contends that major financial managers with a wealth of newly acquired capital have the potential for success moving forward. However, the article predicts mounting complexity and greater challenges for smaller financial managers who aren’t flush with assets. To arrive at these conclusions, the authors of “Sailing into Uncharted Waters” spoke to finance sector leaders ranging from University of Texas clinical professor of finance Ken Wiles to Atalaya Capital Management founding member and chief investment officer Ivan Zinn.

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How Subscription Credit Facilities Are Structured in Fund Financing

An established Chicago lawyer, Zac Barnett serves as Fund Finance Partners, LLC, managing director. As an attorney, he is tasked with coordinating private funding vehicles that provide liquidity to a range of companies. Attorney Zac Barnett is conversant in fund financing as an alternative to traditional bank loans, which often entail rigorous and time-consuming lending requirements.

Fund financing facilities extend credit through vehicles that make investments and are structured as limited partnerships. A general partner administers the fund and limited partners, or investors, subscribe to the fund. This requires both committing a specific amount to the fund and signing a subscription agreement. Funds hold multiple closings as needed as a means of bringing new investors and fresh capital infusions on board.

One important thing to note about such funds is that investors do not have an upfront obligation to finance their entire commitment. Instead, they have a contractual obligation to finance capital calls that the general partner makes. Investors are not involved in active management and have limited liability, and are notified of capital calls through a notice that both states the amount required and the purpose to which the money is to be allocated. Common uses range from repayment of debt obligations to follow-on investments that enable funds to grow.

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Private Credit Weathers Banking Turbulence

Attorney Zac Barnett is a Chicago lawyer who guides Fund Finance Partners, LLC, and delivers creative debt capital raising and investment solutions. In May 2023, Zac Barnett’s insights as an attorney on banking turbulence and the private lending landscape were featured in a Private Debt Investor cover story.

In the aftermath of the implosion of institutions such as Silicon Valley Bank and Credit Suisse and a landscape of increased bankruptcies and defaults, regulations tightened and banks become more likely to pull in loans. This presented an opportunity for veteran private debt managers with cash at hand to gain market share from banks. At the same time, it negatively impacted those asset managers overly reliant on conventional bank credit.

As described in the article, the outlook is one of private credit heading for a major test, in which some investors will attain the higher returns they expect, while others bear the brunt of unrealistic expectations in a turbulent market. Compounding this, high interest rates may make equity infusions insufficient for invested companies to achieve sustainable growth.

With the failure of some businesses inevitable, it’s critical to monitor how relationships between fund sponsors and lenders evolve. As one industry executive put it, senior secured lenders hold “the upper hand,” as they are more likely to recover assets and capital from failed companies.

Moving forward, private equity has a large role to play, as the next decade will require extensive credit forwarded to the leveraged loan market, which totals $1.7 trillion and is mostly in the form of collateralized loan obligations (CLO).