The two ways to raise liquidity against a private equity portfolio, priced over three years in five portfolio outcomes, with the fire sale a NAV loan's covenant can force.
Preferred equity costs a private equity fund more than a NAV loan in almost every outcome, and the difference is the price of not having a loan-to-value covenant. On an illustrative $150M raised against a $1,000M portfolio for three years, a NAV loan at 10.00 per cent with a 1.50 per cent fee costs $51.9M; preferred equity at a 13.0 per cent compounding return plus 5 per cent of later distributions costs $107.1M if the portfolio is flat. Preferred equity only becomes cheaper if, after a 40 per cent fall, the loan's covenant forces sales at more than a 31.1 per cent discount. All costs are undiscounted totals over the three years.
Worked in full in The Fund Finance Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Both instruments give a fund liquidity late in its life: to support portfolio companies, to make a distribution, or to bridge to exits. The NAV loan is debt with a covenant and a fixed cost. Preferred equity sits ahead of the limited partners, takes a higher return and a share of the upside, and has no maintenance test to breach. Comparing them on headline rates misses both the upside share and the covenant, so the comparison has to be run across outcomes.
| Term | NAV loan | Preferred equity |
|---|---|---|
| Amount | 150.0 | 150.0 |
| Portfolio NAV at closing | 1,000.0 | 1,000.0 |
| Rate | SOFR 4.00% + 6.00% = 10.00%, accruing | 13.0% preferred return, compounding |
| Upfront fee | 1.50% | 1.00% |
| Upside participation | none | 5.0% of distributions after redemption |
| Cap on total return | none | 1.75x |
| Maintenance covenant | LTV of 25% | none |
| Repaid from exits at | year 3 | year 3 |
Repayment = 150.0 × 1.10³ = 199.65
Cost = interest 49.65 + fee 2.25 = 51.90, the same in every outcome unless the covenant bites
All-in annual cost = (199.65 ÷ (150.0 − 2.25))1/3 − 1 = 10.56%
Day-one LTV = 150.0 ÷ 1,000.0 = 15.0%; at year 3 the accreted loan breaches 25% if NAV is below 798.6, a fall of 20.1%
Redemption = 150.0 × 1.13³ = 216.43, so 66.43 of preferred return
Participation = MIN(5.0% × (Proceeds − 216.43), 1.75 × 150.0 − 216.43 = 46.07)
Flat portfolio: 5.0% × (1,000.0 − 216.43) = 39.18
Cost = 66.43 + 39.18 + fee 1.50 = 107.11, an annual cost of 19.84%
The participation is what changes the comparison. The preferred return alone is three points above the loan rate, an annual cost of 13.4 per cent after the fee. The share of later distributions takes it to 19.84 per cent in a flat outcome, more than twice the gap the preferred return creates, and it is capped only when the portfolio does well.
If the portfolio falls far enough to breach the LTV covenant, the fund must repay enough of the loan to bring it back to 25 per cent, and in a falling market it repays by selling assets below NAV. The sale needed is (Loan − 25% × NAV) ÷ (1 − discount − 25%). After a 40 per cent fall, with sales at a 15 per cent discount, that is 82.75 of assets sold and 12.41 lost.
| Portfolio change | Proceeds | Loan LTV, year 3 | NAV loan cost | Preferred cost | Preferred annual cost | Extra cost of preferred |
|---|---|---|---|---|---|---|
| −40% | 600.0 | 33.3% | 64.31 | 87.11 | 16.63% | 22.80 |
| −20% | 800.0 | 24.96% | 51.90 | 97.11 | 18.26% | 45.21 |
| Flat | 1,000.0 | 20.0% | 51.90 | 107.11 | 19.84% | 55.21 |
| +20% | 1,200.0 | 16.6% | 51.90 | 114.00 | 20.91% | 62.10 |
| +33.1% (10% a year) | 1,331.0 | 15.0% | 51.90 | 114.00 | 20.91% | 62.10 |
The preferred equity is dearer in every row. Its cost rises with performance until the 1.75x cap binds at 114.00, while the loan's cost is flat until the covenant breaks. The gap is narrowest exactly where the fund needs help: after a 40 per cent fall it is 22.80, against 55.21 in a flat outcome. A 20 per cent fall leaves the loan at 24.96 per cent, a whisker inside the covenant, which is a reminder that an accruing loan moves towards its trigger even when nothing else happens.
After a 40% fall, NAV loan cost including the forced sale:
Discount 15%: sale 82.8, loss 12.41, cost 64.31
Discount 25%: sale 99.3, loss 24.83, cost 76.73
Discount 35%: sale 124.1, loss 43.44, cost 95.34, now above the preferred cost of 87.11
Break-even discount: 31.1%
That is the real decision. Preferred equity is insurance against a forced sale at a deep discount in a severe drawdown. A fund with liquid, diversified positions that could be sold near NAV should take the loan. A fund concentrated in two or three companies, where selling a stake in a bad market could mean a discount of a third, is buying something real with the extra cost.
The limited partners pay either way. In the flat case the LPs keep 800.3 of the 1,000.0 after repaying the loan and 744.4 after the preferred equity. Any investor reading a fund's quarterly report should ask which of the two sits ahead of them and on what terms. What a loan-funded distribution does to the fund's reported DPI and TVPI is worked in what a NAV loan distribution does to DPI.
The common mistake is to compare the headline rates, 10.00 per cent against 13.0, and conclude that preferred equity costs three points more. Over three years and a flat portfolio the cost is 107.11 against 51.90, more than double, because of compounding and above all the participation. The reverse mistake is to treat the loan's cost as fixed. It is fixed only while the LTV covenant holds, and the cost of a breach depends on the price at which assets can be sold in the quarter it happens.
The book's NAV facility underwriting, from reported NAV to lending value and the downside the covenant must survive, is in the free workbook for this case. How far NAV can fall before a breach, on the covenant's own adjusted base, is worked in how far NAV can fall before a NAV facility breaches its LTV covenant.
Usually, because the investor takes more risk and is paid for it with a higher preferred return and a share of the upside. In the worked case the NAV loan costs 10.56 per cent a year all in, while preferred equity costs between 16.63 and 20.91 per cent depending on how the portfolio performs, or $87.1M to $114.0M on $150M over three years.
To avoid a loan-to-value covenant. A NAV loan that accretes to $199.65M breaches a 25 per cent LTV once the portfolio falls 20.1 per cent, and curing it after a 40 per cent fall means selling $82.75M of assets at a 15 per cent discount, a $12.41M loss. Preferred equity has no such trigger, so it suits funds that cannot risk a forced sale.
It is structured as equity in the fund or a vehicle below it, so it does not usually sit in a debt covenant, but economically it ranks ahead of the limited partners. In the base case it takes $255.6M of the $1,000M of proceeds, leaving the LPs $744.4M, against $800.3M after repaying a NAV loan.
This article is one calculation from The Fund Finance Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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