Alternative Investment Management Association
James Tinworth, Partner
Before the financial crisis, it was relatively common for a hedge fund manager to offer, or at least to be asked to offer, more leveraged access to one or more of its strategies. Investor appetite for more leveraged access reduced but there are signs that this appetite is returning.
This article explores the ways in which a manager of an existing fund can offer more leveraged access to its strategy and describes the pros and cons of each. It assumes that the existing fund is a single-legged master-feeder structure consisting of two offshore investment companies.
Option One: set up an entirely new fund structure (i.e. a new feeder and new master)
There are many examples of managers promoting two funds that pursue the same strategy. One fund would be less leveraged (e.g. "ABC Fund Limited") and the other would be more leveraged (e.g. "ABC Leveraged Fund Limited" or "ABC 2X Fund Limited").
Whilst this option may be cleaner and more straightforward than others, it is one of the most expensive to establish (i.e. it would require a new fund launch). The structure would not maximise economies of scale (e.g. it would at least duplicate the operating costs of the existing structure and there would be two separate pools of assets). The two pools would be managed in parallel and this would present operational and legal issues, particularly if there is any formal rebalancing arrangement. There would be four entities to manage and two sets of trading relationships to deal with.
Option Two: have a new feeder fund investing in the original master fund where this new feeder would borrow
In this option, the leveraged feeder fund would borrow to leverage up investors' subscriptions to the appropriate ratio and would invest this leveraged amount into the master fund. The leveraged feeder and its investors would therefore get a higher level of exposure to the master fund's trading portfolio than the unleveraged feeder and its investors.
The lender would want to obtain security on master fund assets. It should, however, have limited recourse only to those assets that are attributable to the leveraged feeder.
In practice, this option may not be feasible and financing may not be available in any event. In theory, however, this option would improve on Option One. There would be no contagion risk (i.e. the investors who do not want any more leverage would not be exposed to it). There would be one pool of assets. There would be one extra entity to operate but only one set of trading relationships to deal with. This option would still be expensive to establish and to operate (particularly in relation to ongoing financing costs) and, for the moment at least, it is likely to remain a theoretical option only.
Option Three: arrange borrowing facilities to be available for individual investors
In this option, the extra leverage would be created outside of the fund structure as the investors themselves would leverage up the level of their investment into the feeder fund. This option would be expensive for investors and care would have to be taken to ensure that the lender would only have recourse to those master fund assets that are attributable to a defaulting investor.
Even if satisfactory security arrangements were put in place, it is difficult to see how the situation could be avoided where each investor would be subject to individual credit approval by the lender.
Option Four: a structured product
A variant of Options Two and Three would be to approach an investment bank to put together a structured product or to use an existing platform to provide the leveraged access. Whilst this would solve some of the issues presented by Options Two and Three, the fundamental point is that the structured product would be operated and controlled by the bank.
Option Five: using share classes in the existing feeder fund (without having a new master fund)
There are various ways to achieve different gearing levels between share classes:
(a) Increase the leverage limit of the master fund and use an appropriate formula to retain the correct percentage of the less leveraged share class in cash/near cash at feeder fund level and only invest the remainder in the master fund. This is not particularly attractive, however, as investors could just invest less in the more leveraged share class and by investing this way they are not really getting the desired exposure to the strategy. Being facetious for a moment, you could achieve an equivalent effect by increasing the leverage used by the existing master fund and asking investors who want less leveraged to invest less.
(b) The feeder fund could borrow against the more leveraged share class and invest this leveraged amount into the master fund. Alternatively, it could invest the subscription monies in respect of the more leveraged share class into an intermediary vehicle, which would then borrow and invest the leveraged amount into the master fund. In either case, the same issues described under Option Two would apply and I am not certain that either option would be any more feasible than Option Two.
(c) Use an appropriate formula to determine the amount of leverage at master fund level and allocate profit and loss between the less leveraged share class and the more leveraged share class in the appropriate ratio. For example, if investors in the less leveraged class were exposed to leverage of 250% of NAV and investors in the more leveraged share class wanted twice as much leverage then, if there was an equal investment in the two share classes, the master fund would leverage to 375% of NAV and profit and loss would be allocated between the two share classes on a 2:1 ratio.
The latter route is probably the easiest but would present contagion risks. In any event, it is likely that the funds' articles would need to be amended and shareholder consent would need to be obtained. This is because a holder of one share in the feeder fund would usually have a proportionate interest in all the assets of the feeder fund and, with the majority of these gearing options, the interest of a current investor would be changing.
If the contagion risks can be acceptably managed, Option Five is probably the most attractive. It would be less expensive than establishing new vehicles and should be cheaper and easier to operate as the access to the extra leverage is housed within the two existing entities.
Option Six: having a new master fund
This option would also require new share classes in the feeder fund. It would also be likely that the fund's articles would need to be amended and shareholder and consent would need to be obtained because an investor who currently has an interest in all the assets of the feeder fund would only get an interest in the assets of the less leveraged master fund.
Whilst this option would solve the contagion issues, which could be created in Option Five, it would be more expensive to implement and operate, there would be two separate pools of assets that would be managed in parallel, there would be three entities to manage and two sets of trading relationships to deal with.
There are many ways to offer more leveraged access to a strategy and there is no one-size-fits-all solution. Each option has its own pros and cons and may be more or less suitable depending on, amongst other things, the manager, the investors, the strategy and the situation.
Managers should carefully consider the impact that offering more leveraged access to a strategy could have on liquidity management. Managers and fund directors should also ensure fair treatment of the existing investors who do not want to be exposed to additional leverage and who may not want to invest side-by-side with investors who do.
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