Questions about venture fund liquidity.
Direct answers on distribution financing: what it is, what it costs, who approves it, and how it interacts with carry, QSBS, tax and the venture capital exemption.
The basics
What is distribution financing for venture funds?
Distribution financing gives a venture fund cash today in exchange for a priority claim on its future distributions. An investor advances a share of the fund's NAV. The fund distributes that cash to its LPs. As portfolio companies exit, an agreed share of the fund's proceeds repays the investor until it has received a fixed preferred return. Then its claim ends, and all remaining proceeds go to the fund's partners.
It is also called NAV preferred equity, a preferred distribution facility, venture NAV financing or a distribution strip.
How can a venture fund generate DPI without selling assets?
A fund can borrow against its portfolio with a NAV loan, or take distribution financing, and distribute the proceeds. Either way it keeps its companies and their upside. Distribution financing has no maturity date and no loan-to-value tests, so slow exits do not trigger a default. The other routes to DPI, such as secondary sales, strip sales and continuation vehicles, all involve selling something, usually at a discount.
How is it different from a strip sale or continuation vehicle?
A strip sale or continuation vehicle sells assets, usually at a discount, and the buyer keeps the upside on what it bought. Distribution financing sells nothing. The fund pays a fixed, capped return instead, and keeps all upside above it. A continuation vehicle also gives cash only to LPs who elect to sell, while distribution financing reaches every LP pro rata.
What it costs
What does distribution financing cost?
The investor receives a fixed preferred return: the greater of an IRR hurdle and a multiple of the advance, with a cap on the total. Pricing depends on the portfolio's maturity, concentration and mark quality. Unlike a sale, the cost does not grow if the portfolio outperforms.
What does a sale at a discount cost LPs compared with a preferred strip?
Take a $100MM fund carrying $300MM of NAV that wants to put $60MM in LPs' hands. It can sell 25% of its interests at 80% of NAV, or take a $60MM preferred strip. If the fund ultimately distributes $400MM, the sale costs LPs $100MM of future proceeds and the strip, under the calculator's default assumptions, about $84MM. The strip costs less whenever the fund realizes more than about $337MM, roughly 112% of its current NAV. Below that, the sale costs less.
What happens if the fund's exits are slow?
Nothing defaults. The investor's IRR leg keeps accruing until it reaches the cap, and the terms step up if the advance is still outstanding after an agreed period. Later remedies, such as the right to require a sale process, apply only after several years.
What happens if the portfolio falls short of its marks?
The investor is still repaid first from whatever the fund distributes, but its claim is non-recourse. If total distributions never reach its preferred amount, the investor bears the shortfall. LPs are never asked to return the advance. In a weak outcome, distribution financing costs LPs more than a discounted sale would have.
Does the GP still earn carried interest?
Yes, through the fund's normal waterfall. The investor's return is usually charged as a fund expense before carry is calculated, so the GP bears its share of the cost. In many mature venture funds the advance is simply a return of LPs' capital and generates no carry. Where it would, some deals hold that carry in escrow until the investor is repaid.
Process and approvals
What approvals does a fund need?
Usually LPAC consent, plus confirmation that the LPA permits the arrangement, its security and the distribution of the proceeds. If the LPA's borrowing or lien provisions do not allow it, an LP vote is needed. An LP-level arrangement needs only the GP's acknowledgment.
Do portfolio companies need to consent?
Not in a contractual structure. The fund keeps legal title to its shares and agrees to pay the investor a share of its proceeds, secured on the account those proceeds are paid into. No shares move, so no company consents or rights of first refusal are triggered. Holding-vehicle structures that move shares into a new entity do trigger them.
How is the advance sized?
By how far the portfolio could fall before the investor's preferred amount is at risk. The main inputs are portfolio maturity, concentration in the largest one or two companies, the age and terms of the latest marks, and any public or near-public positions. Diversified, mature portfolios support larger advances than concentrated ones.
How long does it take?
Typically one to three months, driven mostly by diligence on the portfolio and the fund's approval process.
For LPs
Can an LP get liquidity without selling its interest?
Yes. The same structure can be offered to a single LP against its interests in one or more venture funds. The LP receives cash today and pays the investor a share of the distributions it receives until the preferred amount is paid, keeping its interests and their upside. Interests in several funds can be combined to support a larger advance. The LP keeps funding its capital calls, and the GP of each fund acknowledges the arrangement.
Regulatory and tax
Can a fund relying on the venture capital exemption take on leverage?
Only within narrow limits. An adviser relying on the venture capital fund exemption must manage funds that meet Rule 203(l)-1. Under paragraph (a)(3), a qualifying fund may not "borrow, issue debt obligations, provide guarantees or otherwise incur leverage" above 15% of its capital contributions and uncalled commitments, and any such borrowing must have a non-renewable term of no more than 120 days.
Multi-year fund-level financing, including NAV loans and fund-level distribution financing, can exceed those limits. An LP-level arrangement, where an LP finances its own interest, is not the fund's borrowing, so it works for LPs in funds of venture-exempt advisers. Fund counsel should confirm how a specific structure is treated.
Does distribution financing affect QSBS?
A contractual structure leaves the portfolio stock where it is, so it does not change the fund's holding of qualified small business stock. Structures that move stock into a new partnership or holding vehicle can jeopardize Section 1202 treatment for taxable LPs. Tax counsel should confirm the treatment for a specific fund.
How is distribution financing treated for tax purposes?
It depends on the structure. A contractual arrangement is generally intended to be treated as debt of the fund, which affects LPs' basis and, for tax-exempt LPs, whether any income is debt-financed. Holding-vehicle structures are generally intended as equity but can raise disguised-sale questions. This is general information, not tax advice.
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General information, not legal, tax or investment advice.