Return to search

International funds consider the transition to a NAV-based liquidity alternative for currency hedging

The proliferation of NAV-based lending makes it possible for closed-end funds to transition away from bank credit lines for their currency hedging needs. Mark Battistoni of HedgeNAV LLC explains.

In the wake of the financial crisis, derivatives markets braced for regulators to impose mandatory daily cash collateral (variation margin, or VM) on all financial entities, including closed-end private funds. As this would have made fund-level currency hedging highly impractical for these investors, rumors swirled of banks planning fund-level loans to meet liquidity needs under the new VM regime.

Despite phasing in sweeping reforms, regulators left private funds enough room to continue hedging, and most people have not thought about using fund-level loans for Variation Margin since. This construct has now resurfaced, offering funds with material hedging needs an alternative to the status quo.

Outdated model

Mark Battistoni

Posting VM has always been a non-starter among closed-end funds, for both economic and operational reasons. Instead, for more than two decades the standard market practice has entailed bilateral credit lines in the form of derivatives framework agreements between a fund-level entity and each of its chosen hedge counterparty banks. Though effective at preventing VM, these bank credit lines can introduce other fund-level challenges.

At a high level, their design is sensible. Each credit line entitles the fund to avoid posting margin if the aggregate mark-to-market valuation of its hedge portfolio with that bank remains below pre-defined thresholds. If the valuation ever exceeds the threshold the fund only posts VM on the difference, and only with that specific bank.

The problem is that they are too small. Being 2-4 percent of a fund’s net worth all but forces funds to arrange several credit lines to reduce the likelihood of ever posting VM. Redundancy brings several benefits to the fund but worsens the credit position for its group of hedging banks. That is because:

  1. They sit among an unknown number of other creditors with similar, but not identical, derivatives credit line arrangements with no inter-creditor agreement.
  2. They only receive updated financial information about the fund after delays of 30 or more days.
  3. They do not have real-time access to the fund’s complete hedging activities, resulting in poor visibility of the fund’s total exposure and their exposure relative to other banks.

Consequently, hedging banks seek to include a range of protections when negotiating credit lines. By far the most notable of these is a “minimum liquidity” provision that has become increasingly standard in recent years. It reduces the threshold to zero if the fund’s available cash and uncalled capital commitments fall below a fixed amount. This figure is effectively the bank’s estimate of the fund’s potential future aggregate hedging liabilities, often $50 million to $150 million, depending on fund size and other factors.

As a fund’s mandate is to invest LP capital, this provision is nearly as bad as posting margin. It also makes little financial sense: when (correctly) factoring in the opportunity cost of not investing capital, hedging quickly becomes uneconomical. And if a fund continues to hedge because (fortunately) some of its hedging banks do not have minimum liquidity provisions, its liquidity risk is higher as hedges are dispersed among fewer counterparties.

Where NAV facilities come into the picture

To tackle the root problem, a bank could offer to increase its threshold to, say, 6-12 percent of a fund’s net worth and drop its minimum liquidity provision. In exchange, it would become the fund’s exclusive hedging counterparty and control the fund’s bank accounts. Its fund client could thus invest LP capital fully and continue hedging deep into its harvest period.

Even with vastly improved visibility and control, this bank would struggle to convince its regulators that multiplying its exposure has any merit. It is simply inconsistent with the sweeping derivatives regulatory reforms effected over a decade ago.

Enter the growing coterie of non-bank NAV-based lenders that have entered the market to tailor solutions to funds’ specific liquidity needs. These firms can readily underwrite exposures of 25-35 percent of a fund’s NAV and would also benefit from a fund’s hedging program if one were in place.  Their main obstacle for supporting a fund-level hedging program with a NAV facility is a lack of infrastructure to offer derivatives transactions. This is where VM comes in.

Funding VM with NAV

By funding VM through a NAV facility, a fund effectively bifurcates the market risk and credit risk components of its hedging bank relationships. The hedging banks retain the market risk, whereas the credit risk and capacity move to the (bank or non-bank) NAV facility provider. This entails changing the fund’s hedging bank credit line documentation to reflect “trading-only” lines subject to full VM.

Operationally, funded by the NAV facility, the fund makes VM payments to its remaining hedging banks. This would likely be facilitated by a custodian bank, with which the NAV-based lender would either have a credit or VM relationship to ensure no funding delays.

The margin on a NAV facility will be higher than the implied margins of banks’ credit charges under most credit lines. However, an “apples to apples” comparison would account for the full terms and conditions of each regime. As cited earlier, if a fund’s credit lines have minimum liquidity provisions, the opportunity cost of these need to be added to the implied margins on banks’ credit charges. Continuing a hedging program with a NAV facility can be economically compelling, by comparison.

Managers contemplating such a transition need not wait until the very end of their fund’s investment period to start the process. NAV-based lenders merely require a portfolio to be mature; it does not need to be complete. Transaction timelines are situation-dependent, but lenders generally aim to close transactions within six to eight weeks.

In the fund finance realm, NAV facilities have gained prominence in recent years. Non-bank NAV-based credit providers bring a range of useful liquidity solutions to market, and they are serving all sizes of concentrated investment portfolios typical to corporate private equity and real estate funds, separate accounts and even continuation funds.

Fund finance has entered an exciting period in which persistent challenges are being reassessed. For fund-level hedging programs, avoiding VM was the rule. Now it may prove to be a surprisingly welcome exception.

Mark Battistoni is a founding member at HedgeNAV