Private Equity Valuation for Lending: What Actually Works
Private Equity Valuation for Lending: What Actually Works
Private equity fund interests are fundamentally different from anything else in a borrower's portfolio because there's no market price, no daily quote, no bid-ask spread you can look up on Bloomberg. Yet these interests often represent the largest single asset class for high-net-worth borrowers, and those borrowers frequently want liquidity without triggering sales.
This creates a tension that sits at the heart of pledged-asset lending: borrowers want credit against demonstrable wealth, while lenders need reliable collateral values. Getting this wrong in either direction is expensive because lending too aggressively leads to losses when values drop, while lending too conservatively loses deals to competitors who understood the asset class better.
The NAV Problem
General Partners report Net Asset Value quarterly, sometimes monthly for larger funds. The number represents the GP's estimate of what the underlying portfolio companies are worth minus liabilities, and most GPs follow ILPA guidelines and ASC 820, which means fair value measurement, consistent methodologies, and independent audit of annual valuations.
The problem is timing.
Consider the actual timeline: the quarter ends on March 31, portfolio companies report financials through April and May, the GP performs valuations in May and June, and the LP receives NAV in late June or July. By the time an LP sees that number, the underlying data is three to four months old, and if public markets have moved significantly during that period, the reported NAV may bear little resemblance to current reality.
Beyond staleness, NAV involves judgment. Different GPs applying similar methodologies to similar companies reach different conclusions because the choice of comparable companies matters enormously, and a GP might unconsciously emphasize comparables that support higher valuations. This is the nature of estimating fair value for illiquid positions.
The J-curve effect compounds these issues for younger funds because management fees, organizational costs, and early-stage investments that haven't appreciated yet depress NAV in a fund's early years, meaning NAV may significantly understate long-term value for funds in years one through three.
Secondary Market Reality
The private equity secondary market provides something NAV cannot: actual transaction prices between willing buyers and sellers. Forge, Lexington Partners, and other intermediaries facilitate these trades, and the data aggregators track what's happening.
Secondary market data tells you what buyers are actually paying rather than what GPs think positions are worth. When the secondary market is trading a fund at a 25% discount to NAV, that discount reflects buyers' independent assessment of the portfolio, liquidity considerations, and their own return requirements.
The limitation is coverage because transaction volume varies by market conditions, any individual fund interest may lack recent trades, and secondary buyers apply their own assumptions about future performance. But where secondary data exists, it's more reliable for lending purposes than NAV alone.
Setting Advance Rates
Given these valuation uncertainties, advance rates for PE collateral need to be conservative. The actual numbers depend on fund characteristics, but here's roughly what we've seen work.
Large buyout funds in mature vintages typically support advance rates in the 60-75% range because these funds have established portfolios, regular distributions, and often active secondary markets. The valuation uncertainty is manageable.
Mid-market and growth funds run lower, often 50-65%, because the portfolios tend to be more concentrated, the secondary markets thinner, and the time to liquidity less predictable.
Venture capital funds are the most challenging because exit outcomes are binary and a single company can represent most of the value. Advance rates of 30-50% are common, and some lenders avoid them entirely.
Funds in the J-curve present a particular challenge because the current NAV may substantially understate eventual value, but you cannot lend against anticipated performance. Either apply aggressive haircuts or wait until the fund matures.
The Operational Realities
Beyond valuation, PE collateral creates operational complexity that liquid assets lack.
Unfunded commitments are the big one. If your borrower has $1M in NAV but also owes $500K in future capital calls, you need to think about that obligation because a borrower who can't fund a capital call may face dilution or forfeiture. Some lenders require capital call reserves, while others will advance funds for calls, adding to the loan balance but protecting the collateral. Either approach works, but you need a clear policy before closing.
Distribution handling matters too because PE funds return cash as investments are realized, and those distributions reduce your collateral base. Most structures sweep distributions to pay down the loan, reducing exposure proportionally, while some allow borrowers to retain distributions up to a threshold. The right answer depends on your risk tolerance and the borrower's needs.
Transfer restrictions are nearly universal because the GP must typically consent to any pledge and has a right of first refusal on any transfer. Before you close a loan, you need that GP acknowledgment in hand because otherwise your security interest may be unenforceable when you need it.
Documentation That Works
The core documents are familiar from other secured lending, but the details matter more.
The security agreement needs to clearly identify the pledged interests, avoiding generic references like "borrower's LP interest in Fund X." Get the entity name exactly right, specify the percentage interest, and include representations that the borrower actually owns what they're pledging and has authority to pledge it.
The GP acknowledgment is unique to this asset class. You need the GP to confirm receipt of notice of the security interest, agree to provide NAV reports directly to you, and commit to honoring your instructions upon default without requiring further borrower consent.
A UCC-1 filing provides backup protection and public notice, and while it won't give you priority over a control-based interest, it provides protection against other filers and gives notice to anyone doing due diligence on the borrower.
Before accepting any PE collateral, read the LP agreement. Look for transfer restrictions, GP consent requirements, default provisions that might affect transferees, and anti-assignment language. Some LP agreements make pledges nearly impossible, and you want to discover that before underwriting rather than after.
Ongoing Monitoring
You cannot value PE collateral once and forget about it because quarterly revaluation is table stakes. Track NAV updates, distribution activity, capital calls, and changes in portfolio composition.
Build a margin framework appropriate for the asset class. PE values don't move daily like public equities, but they can move significantly when they do move, with a major portfolio company write-down shifting NAV 20% in a single report. Your cure periods and margin thresholds need to account for the quarterly reporting cycle.
Watch for early warning signs: delayed NAV reporting, methodology changes, significant write-downs, GP organizational issues, sector stress affecting portfolio companies. By the time these issues show up in NAV, you want to have already adjusted your exposure.
Why Bother?
PE lending is harder than lending against public securities because the valuation is uncertain, the liquidity is limited, and the documentation is complex.
But the borrowers are creditworthy, the yields are attractive, and the competition is limited. Most banks lack the expertise to underwrite PE collateral, and most private lenders lack the regulatory framework to do it at scale. For institutions that build the capability, PE lending accesses a market segment that's significantly underserved.
The key is building the infrastructure before scaling the portfolio: understand the valuation challenges, build relationships with GPs for acknowledgments, develop monitoring capabilities for quarterly reviews, and get the documentation right the first time.
Do that work upfront, and PE becomes a sustainable product line. Skip it, and you'll learn expensive lessons from your loan book.
For specific guidance on structuring loans against private equity interests, consult qualified legal and valuation professionals.
