NAV Loans and Fiduciary Duties
NAV Loans: Navigating Fiduciary Duty Obligations
Net Asset Value (NAV) loans have become an increasingly popular liquidity solution for private equity funds. These loans, secured against the residual value of a fund’s portfolio, provide flexibility for general partners (GPs) to manage cash flows, make follow-on investments, or return capital to investors. Even though fund documents may permit a GP to enter into NAV loans or be silent on the matter, that does not necessarily grant unrestricted authority. A GP’s fiduciary duty to the fund may still prevent them from engaging in transactions that present conflicts of interest. As a result, careful consideration must be given to a GPs fiduciary obligations before executing such loans.
Waivability of Fiduciary Duties Under Partnership Law
In private equity fund structures, fiduciary duties typically arise under the partnership agreement governing the relationship between the GP and the limited partners (LPs). Delaware partnership law, which governs many onshore private equity funds, permits significant contractual modification of fiduciary duties. Specifically, under the Delaware Revised Uniform Limited Partnership Act (DRULPA), the partnership agreement can waive or limit the GP’s fiduciary duties, including duties of care and loyalty. This means that a GP may, through explicit provisions in the partnership agreement, limit its obligations concerning certain conflicts of interest, self-dealing, and fair dealing.
While waivers can provide flexibility, they are not absolute. Delaware courts have held that the implied covenant of good faith and fair dealing cannot be eliminated, ensuring that a GP cannot act in bad faith even where fiduciary duties are waived.
It is important to note that many partnership agreements historically contemplated only short-term financings, such as subscription lines of credit, and did not specifically address NAV loan structures. As a result, GPs should carefully review the partnership agreement and consider seeking LP or LPAC consent (if permitted) to amend the agreement before executing such transactions to the extent NAV loan structures are not specifically addressed.
The Non-Waivable Fiduciary Duty Under the Investment Advisers Act of 1940
While a GP’s fiduciary duties under the partnership agreement can be modified or waived pursuant to Delaware partnership law, its fiduciary obligations under the Investment Advisers Act of 1940 (the "Advisers Act") remain intact. The Advisers Act imposes a broad fiduciary duty on registered investment advisers, including GPs who manage private equity funds and provide investment advice for compensation.
The fiduciary duty under the Advisers Act, as interpreted by the Securities and Exchange Commission (SEC) and reinforced in case law, consists of both a duty of loyalty and a duty of care. This duty is non-waivable and applies to all aspects of fund management, including the structuring and implementation of NAV loans. In particular:
Duty of Loyalty: Requires full and fair disclosure of material conflicts of interest, including any benefits a GP may receive from a NAV loan.
Duty of Care: Requires that the GP act in the best interests of the fund and its investors, ensuring that any NAV loan is prudently structured and aligned with the fund’s investment strategy.
This means that even if a GP obtains contractual waivers of fiduciary duties from LPs under the partnership agreement, it must still adhere to the fiduciary obligations mandated by the Advisers Act. Any NAV loan transaction that unduly enriches the GP, lacks proper disclosure, or is not in the best interests of the fund could invite SEC scrutiny and potential liability.
In particular, NAV loans that are designed primarily to distribute proceeds to investors—thereby crystallizing the GP’s carried interest—will be particularly scrutinized by the SEC. The SEC has expressed concerns that such transactions may prioritize the GP’s compensation over the fund’s long-term interests, potentially leading to conflicts of interest. GPs must ensure that these loans are structured transparently, with full disclosure to LPs and a clear alignment with the fund’s overall investment objectives. To mitigate regulatory risks, GPs should consider obtaining the consent of LPs or the Limited Partner Advisory Committee (LPAC) before executing these transactions even if the fund documents specifically addressed NAV loan structures.
Key Takeaways
GPs can contractually waive fiduciary duties under the partnership agreement to the extent permitted by state law, such as Delaware law, but they must still act in good faith.
The fiduciary duty imposed by the Advisers Act cannot be waived, meaning that even with a waiver in the partnership agreement, the GP remains bound to act in the best interests of the fund and its investors.
NAV loans require careful structuring and full transparency to avoid conflicts of interest and ensure compliance with both contractual and regulatory fiduciary obligations.
NAV loans structured to distribute proceeds and crystallize carried interest are subject to heightened SEC scrutiny and should be carefully evaluated to ensure they align with investor interests and regulatory requirements.
GPs should consider seeking LP or LPAC consent for NAV loans to mitigate regulatory risk, particularly those structured to accelerate carried interest distributions.
In the past, partnership agreements often did not contemplate NAV loan structures or their associated costs, so GPs should carefully review agreements and seek amendments where necessary to ensure compliance and transparency.
Given the interplay between contractual fiduciary waivers and regulatory obligations, both GPs and LPs should approach NAV loans with a clear understanding of the legal framework governing fiduciary duties. Ensuring compliance with both state partnership law and federal securities law is critical to avoiding legal and regulatory pitfalls.
