By Jonathan P. Blum, Vice president, Investment Funds at Dresdner Kleinwort Benson in New York which provides financial services to hedge funds.
Hedge fund managers and investors are increasingly interested in the effective use of credit to provide investment flexibility, increase returns and more efficiently manage liquidity. Currently, commercial banks generally do not provide margin facilities for the purchase of U.S. equities, which are easily available from prime brokers. What commercial banks are able to do best is to provide short-term lines of credit for liquidity (for example, paying out redemptions), credit against the collateral of foreign securities, and credit against offshore investment fund shares or U.S. limited partnership interests which prime brokers are prohibited to use as collateral for loans.
Many hedge fund managers have not fully examined the benefit of using bank credit facilities for their existing funds or the optimal use of credit when setting up new funds. Many investors in hedge funds wish to leverage their holdings and, rather than having the individual investor try to borrow directly from a bank against the value of the fund investment, fund sponsors are finding it convenient and more efficient to set up different series or classes of shares or partnership interests, one leveraged and one not. Master-feeder funds and funds of funds can also benefit from credit facilities from commercial banks.
Proper Facility Structuring
When reviewing the request for credit, one of the main tasks for the bank is to assign the margin percentage it will be willing to lend. This is usually defined as a percentage of the total market value of the fund's investments and cash (defined as "qualifying collateral"). When assigning a margin percentage, a bank will consider the markets which the fund invests in, the volatility of the fund, its diversification, and the correlation of the investments with each other. In addition to the fund's information memorandum and constituent documents, audited statements and historical performance data, a single manager fund should be prepared to provide a recent listing of all securities in its portfolio. For a fund of funds, the redemption schedule of the underlying funds is of paramount consideration and the less frequent the redemption period, the lower the margin percentage will be. Generally, a single margin percentage is applied against all the assets of the fund, which can be thought of as a weighted average of what might be assigned to each individual asset. A fund of funds should expect a conservative margin to be applied to the fund's asset base, usually ranging from 20% to 40% (equivalent to 25% to 66 2/3% of the equity capital), depending upon the factors discussed above. A 50% margin in the case of margin stock directly held by the bank as collateral is the limit as required by Regulation U.
Typically, a credit facility will be structured as a committed revolving line of credit, renewable annually, with the assets of the fund held as collateral. The valuation of the fund is prepared by the independent fund administrator and provided weekly or monthly as established by the fund's constituent documents. This is used to set the lending base and monitor the collateral. As most funds require the flexibility of a credit line for both short-term liquidity as well as for investment or leveraging purposes, the commitment amount is typically established as the maximum amount which a fund can borrow after applying the assigned margin percentage plus sufficient excess to allow for the growth of the fund's assets over a reasonable period of time, usually six to twelve months. The borrowing limit of the fund on an ongoing basis is the amount the fund can borrow based on its assets after applying the margin percentage. This is known as the margin collateral value.
The pricing of a credit facility will depend upon the relative risk of the borrower and the collateral, and the complexity of the facility. A fund can expect to pay a 1% to 2% spread over LIBOR. Readily marketable U.S. equity securities will clearly be priced at a lower spread than emerging market securities which are inherently more risky. Hedge fund investors should realize that the investment fund can borrow more efficiently and less expensively than the investors themselves. Typically, banks would prefer to make one larger loan to a fund, than many smaller ones to individual investors because of collateral and efficiency considerations.
Banks will also charge a facility fee (or commitment fee) of 20 to 25 basis points on an annual basis and applied normally to the total commitment amount or, in the case of larger, syndicated credits, to the undrawn portion of the commitment amount. In addition, the bank will charge a one time arrangement fee of 20 to 30 basis points on the total commitment amount and on any increase in the commitment amount. As a practical matter, a minimum facility will be in the range of $5 million to $10 million.
Since most funds find that it is easier and more cost effective to finance individual U.S. equity positions through their prime broker, most banks focus on providing financing against other types of collateral or for other purposes. Increasingly prudent for all types of funds are backup lines of credit to finance redemptions. The collateral for these types of facilities typically would be excess long positions held in a bank's custody, which are not required as margin deposits at a broker. A select number of banks are also active in financing international equities, and investment funds often find bank financing easier to arrange than going to foreign brokers for margin loans on individual positions. Other types of collateral, such as investments in other funds, e.g. limited partnership interests or offshore fund investments, require a greater degree of expertise by lending banks.
Assets provided to the bank as collateral will be held in a custody account in the name of the borrower. In order to take custody of the assets, and to perfect the bank's security interests, all assets used as collateral will be registered in the bank's nominee name (or the nominee of any subcustodian). Typically, U.S. marketable securities or underlying fund interests (e.g offshore investment fund shares) will be held directly by the bank. Any foreign securities will be held through the bank's global subcustodian network. This is determined by where traded securities settle. A borrower should inquire about the lending banks global subcustodian network, as an effective working relationship between the custodian bank and the subcustodian is essential to ensure proper settlement of trades and tracking of the collateral. Limited partnership interests, when taken into custody as collateral for a credit facility, are handled somewhat differently. In this case, the name of the partnership interest is not changed to the lending bank's nominee name. Instead, the general partner of the limited partnership which is being used as collateral is asked to sign a consent and acknowledgment agreement. In the event of a default under the terms of the facility agreement, this allows the lending bank to directly withdraw sufficient funds from the borrower's partnership account to cover whatever is owed to the bank.
Special Facility Structures
More complex fund structures, such as funds with multiple series or classes of shares and master/feeder funds, require careful consideration when structuring a credit facility. The credit facility should be structured so that the bank lends to one series of shares (or limited partnership interests) with recourse limited to the assets attributable to that series of shares on a pro rata basis. The percentage attributable to each series would be set on each valuation date, typically monthly, by the fund's administrator. Once this is done, the margin amount set by the bank would be applied against the pro rata asset value attributable to the series which is borrowing. In this way, a fund sponsor can accommodate both investors wishing to have a leveraged investment in their fund and those investors who do not, while still managing a single portfolio of assets. Clearly, for this approach to work, the bank must have custody of all the assets of the fund, either directly or through a subcustodian. Additionally, a bank must have an effective working relationship with the fund's broker.
Master / feeder funds also can benefit from credit facilities provided by commercial banks. A credit facility could be provided by a bank at either the master or feeder level depending upon the circumstances. For example, a fund of funds may be more interested in a credit line at the master level to facilitate liquidity and for short term investment purposes. On the other hand, a single manager fund (or multi-manager fund with managed accounts), may wish to have the credit line at the feeder level to meet investor requirements. In this case, a bank will ask for a limited recourse guarantee from the master company in order to secure the loan facilities to each of the feeders. This way, a bank is able to obtain the underlying marketable investments as its collateral, rather than shares of the master company which are of limited value as security. It is important that the guarantee be limited to the pro rata share of assets attributable to each feeder in order not to prejudice the "other" group of investors.
One structure which is particularly beneficial for both investors and fund sponsors is to combine the master / feeder structure with the approach of lending to specified series of shares or partnership interests. In this structure, each feeder fund, one an offshore feeder and the other a U.S. feeder, would each establish two series, one leveraged and one not leveraged. The facility documents would specify the recourse assets of each leveraged series as a borrower, defined as the pro rata share of assets attributable to each leveraged series. As discussed above, the fund administrator would provide the actual percentage breakdown of the different series on each valuation date. In this manner, both U. S. and offshore investors can have a choice of a leveraged or un-leveraged product, while the fund manager is managing only one portfolio of assets rather than four separate portfolios, one each for U.S. and offshore investors and one each for investors who may or may not wish to leverage.u