How NAV lenders are approaching ESG

Applying ESG management practices to NAV financing products poses challenges not seen in other types of private lending, according to industry experts.

NAV loans – a form of fund finance in which a fund leverages its assets – are not a new phenomenon in private markets but have been growing in popularity. The market is now estimated to be between $80 billion and $100 billion, Crestline Investors partner Dave Philipp told affiliate publication Private Equity International last year.

The likes of Macquarie Asset Management, Partners Group, Permira and Apollo have all put in place plans to lend to private markets portfolios. AXA IM Prime has already raised $400 million for a dedicated strategy, PEI understands.

Unlike other areas of private credit such as direct lending, NAV lenders must consider not just the sponsor receiving the loan, but also the underlying portfolio companies.

“You have to do due diligence at the manager and the portfolio level,” says Claire Hedley, head of ESG at 17Capital, a fund finance specialist that closed its first NAV lending fund on its hard-cap of €2.6 billion in 2022. The result of this is that obtaining high-quality data may be more difficult: “Right now, most of what we are doing is with qualitative data, but we are working on doing more on the quantitative side.”

For Pemberton’s Pavol Popp, a managing director in the firm’s NAV financing division, the real difficulty does not lie in obtaining data, but predicting how a borrowing sponsor will use the proceeds of the loan.

He says: “If you have a direct lending transaction, you know that you are lending money to a specific portfolio company, and you know what that specific portfolio company is likely to do with that money. [But] We finance the whole fund, and the money could be used in multiple ways.

“For example, the NAV loan could go towards a specific portfolio company to either finance the growth of that company or fix some issues which that company can have. In which case it would be probably easier, it would be a lot similar to the direct lending.

“But probably the main use of NAV financing is to go towards a follow-on investment or towards an add on to the portfolio, which may or may not be identified at the point when you are doing the loan.

“Or even worse, that money could be split among a number of portfolio companies. They may decide how exactly to split it over the next six or 12 months. The money could also go out as a dividend to LPs, in which case the use of proceeds is not fund investment at all.”

Sponsor focus

Considering these challenges, NAV lenders are focusing on the manager to understand ESG risks, rather than going deep on the individual portfolio companies. ”First, you need to look at the manager,” Apollo head of ESG credit Michael Kashani explains. “Are they transparent on their process? Who is doing the diligence? Is it an ESG team off in the corner that no one wants to talk to or are they fully integrated with the investment team?

“Then the question is: does the specific strategy [that we are lending to] deviate from what the manager principally does? So, it is about diving into the fund docs and asking what actually is this strategy? Who is the portfolio manager? How does it deviate? What are the controls around this? Are there any guidelines we need to be mindful of? Are they concentrated? If so, are any of the investments that they are concentrated in potentially an issue for us?”

Pemberton’s approach is similar. Pavol says: “We look more at the sponsor and the fund rather than a specific portfolio company. Is the sponsor likely to use that money for the right things? Do they have proper policies and proper framework and proper checks and balances in place? Assessment of the sponsor is a big part of what we do now.”

Lagging behind

ESG-related developments that have taken place in other areas of private credit are yet to reach the NAV financing world. For example, sustainability linked loans are a rare sight in the space. “We’ve done one but, from experience, they are generally more useful for managers with a less mature ESG strategy to provide an incentive to make progress,” Hedley says. Pemberton is yet to encounter any.

Publicly available ESG Frameworks may also be imperfect for NAV loan purposes. The ESG Integrated Disclosure Project – an initiative that seeks to harmonise ESG disclosures by providing a freely available template – was not designed with NAV lending in mind. Says Hedley: “The ESG IDP is a great initiative, but it is more focused on the direct lending space, so it’s not a perfect fit for us. It’s one of the reasons that we continue to use our own proprietary ESG questionnaire.”

Kashani, who chairs the ESG IDP executive committee, notes that while the ESG IDP was “originally initiated for direct corporate borrowing and the syndicated loan market”, it can still be applied to NAV loans.

He says: “If I am looking at lending to a GP and want an ESG scorecard, the ESG IDP covers that. But then if you are looking at assessing the underlying investments in a borrower’s portfolio, then you could also think about the ESG IDP for that as well. Your ability to request and obtain that information is maybe an added challenge.”