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Total Return Swaps, Structured Repos and SPV Financing (Part One of Two) by Fabien Carruzzo & Daniel King, Kramer Levin Naftalis & Frankel LLP

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Total Return Swaps, Structured Repos and SPV Financing (Part One of Two) by Fabien Carruzzo & Daniel King, Kramer Levin Naftalis & Frankel LLP The definitive source of actionable intelligence on hedge fund law and regulation www.hflawreport.com Vol. 11, No. 14 April 5, 2018 LEVERAGE Three Asset-Based Financing Options for Private Funds: Total Return Swaps, Structured Repos and SPV Financing (Part One of Two) By Fabien Carruzzo & Daniel King, Kramer Levin Naftalis & Frankel LLP Traditional forms of financing – such as cash prime brokerage, How to Structure a Total Return Swap securities lending and plain-vanilla repurchase agreements (repos) – continue to account for a large portion of the Entering Into a TRS financing made available to private funds and asset managers. These types of financing arrangements, however, tend to be A TRS is a derivative contract between the fund and a swap available only for more liquid assets, including equity securities dealer (a bank) to exchange the return of the underlying and bonds, and are generally either callable on demand or (reference) assets that are being financed through the TRS. committed for a short period of time, usually not exceeding six months. The leverage available on a fund’s underlying assets At inception of the TRS, the bank providing the financing will may also be limited by regulatory constraints and capital purchase the underlying assets either from the fund or from a considerations, especially those applicable to broker-dealers. seller of those assets in the primary or secondary market. The As funds seek to use greater leverage; finance esoteric, illiquid bank will either hold the assets directly or set up a separate assets; and obtain financing on a more committed and longer- special purpose entity (SPE) to hold those assets. An SPE term basis, bespoke financing arrangements have become structure may provide tax, operational, accounting and control increasingly popular. (i.e., voting) benefits to the parties that will ultimately be advantageous to the fund. Although many of these tailored products are highly specialized and unique to an asset class or financing objective, TRS Economics a large proportion of esoteric financing can be categorized into three buckets: In connection with the bank’s purchase of the assets, the fund will generally provide some cash collateral in the form of initial 1 . total return swap (TRS) financing; margin, which is also referred to as an “independent amount” 2. structured repo financing; and in swap nomenclature and constitutes a financing “haircut” on 3. special purpose vehicle/entity (SPV) financing. the underlying assets. The bank will typically use that initial margin to fund the acquisition of the assets, but the fund may This article, the first in a two-part series, reviews the main request that the bank segregate the initial margin to provide features of TRS financing, and highlights the comparative greater protection to the fund in the event that the bank fails. advantages and disadvantages to private funds of using this structure, taking into consideration the flexibility, the The bank will then pass the economics of the reference complexity of the legal documentation and the level of asset assets through to the fund in exchange for the fund paying a protection afforded by the structure. The second article will financing charge on the amount initially used by the bank to provide a comparative overview of structured repo financing purchase the assets, as well as costs incurred by the bank in and SPV financing transactions. purchasing, maintaining and administering the assets. Those cash flows are netted and exchanged by the parties, typically For further discussion of financing available to private funds, on a monthly or quarterly basis. see “Types, Terms and Negotiation Points of Short- and Long- Term Financing Available to Hedge Fund Managers” (Mar. 16, For more on asset segregation for derivatives, see “EMIR Offers 2017); and “How Fund Managers Can Mitigate Prime Broker Three Models of Asset Segregation to Fund Managers That Risk: Preliminary Considerations When Selecting Firms and Trade OTC Derivatives” (Apr. 16, 2015); and “A Practical Guide Brokerage Arrangements (Part One of Three)” (Dec. 1, 2016). to the Implications of Derivatives Reforms for Hedge Fund Managers” (Jul. 25, 2013). ©2018 The Hedge Fund Law Report. All rights reserved. 1 The definitive source of actionable intelligence on hedge fund law and regulation www.hflawreport.com Vol. 11, No. 14 April 5, 2018 When the TRS is terminated, either (1) partially because one Credit Support Annex?” (Nov. 8, 2013). of the reference assets pays down, is affected by a credit event or is sold (generally at the request of the fund); or (2) in Key Features of a TRS whole at maturity of the TRS facility, the value of the reference assets will be measured (usually through a sale auction of the TRS financings are highly customizable. They can provide for reference assets carried out by the bank). The fund will receive commitment terms with respect to reference assets, subject from the bank any appreciation in the value of the reference to certain asset and portfolio eligibility criteria designed assets during the life of the TRS, or conversely, the fund will to mitigate certain risks faced by the bank in providing the pay any depreciation in value to the bank. financing, such as liquidity and concentration risks. The bank will also generally cap the maximum amount of financing The transaction will also be marked to market daily based on provided to a fixed dollar amount and require the fund to pay the value of the reference assets, and margin will generally be an unused line or other minimum utilization fees to ensure posted by both parties in light of the requirements imposed by a minimum return on the bank’s financing commitment and the newly enacted uncleared swap margin regulations (unless internal funding costs. the bank insists on one-way margining, for instance via a commensurate initial margin offset mechanism). In most cases, Portfolio criteria as well as unused line or minimum utilization the amount of margin requested by the bank may be disputed fees typically do not apply during a so-called ramp-up period by the fund, in which case the bank will request quotes from at the beginning of the financing to provide the fund with third-party dealers making a market in the reference assets, sufficient time to build up the portfolio of eligible assets. and the margin will be based on quotations provided by those Similarly, those requirements do not apply at the end of the dealers. financing, during a so-called ramp-down period, to provide the fund with some flexibility to unwind the financing and sell See our two-part series on the new swap-margin rules: “Hedge or refinance the reference assets before maturity. Funds Face Increased Margin Requirements” (Feb. 18, 2016); and “Hedge Funds Face Increased Trading Costs” (Feb. 25, Other features that are common in TRS financing 2016). arrangements include: See also “Steps Hedge Fund Managers Should Take Now to • make-whole amounts payable by the fund to the bank in the Ensure Their Swap Trading Continues Uninterrupted When event of an early termination of the TRS facility, and New Regulation Takes Effect March 1, 2017” (Feb. 9, 2017). • obligations to remove certain reference assets from the TRS facility, or for the fund to provide additional initial margin, Documenting a TRS if certain events occur affecting the value of the reference assets or their compliance with applicable asset and TRS transactions are documented using the International portfolio eligibility criteria. Swaps and Derivatives Association (ISDA) documentation architecture, including the credit support annex for margining. In addition, for reference assets requiring active management, [1] The parties will negotiate credit-related terms, such as net voting rights and information flow can be customized to asset value decline termination events and other termination ensure the fund maintains some level of control. events in the schedule to the ISDA master agreement.[2] Given the bespoke nature of these transactions, a confirmation is Advantages of Using a TRS to Finance an Asset also used to set out the terms governing the TRS financing between the parties. Synthetic Leverage For more on ISDA documentation, see our three-part series “Best Practices for Fund Managers When Entering Into ISDAs”: A primary benefit of TRS financing that also differentiates it Negotiation Process and Tactics (Jan. 12, 2017); Negotiating from other financing structures is its synthetic nature. The Event of Default and Termination Event Provisions (Jan. 19, ability of the bank to directly purchase reference assets, and 2017); and Negotiating Collateral Arrangements (Jan. 26, swap the economics of those assets with the fund, obviates 2017). See also “In a Total Return Swap to Which a Hedge Fund the need for the fund to source the full capital needed to Is a Party, Which Governs: The ISDA Master Confirmation or the make an initial acquisition of the reference assets. Moreover, ©2018 The Hedge Fund Law Report. All rights reserved. 2 The definitive source of actionable intelligence on hedge fund law and regulation www.hflawreport.com Vol. 11, No. 14 April 5, 2018 for restricted assets or where confidentiality of ownership is Disadvantages of Using a TRS to Finance an Asset a key consideration for the fund, a synthetic purchase allows the fund to obtain exposure to the reference assets, as well as most of the attributes of ownership, without appearing as the Curtailment of Voting Rights record holder of the reference assets. Although there is scope for flexibility in the documentation, See “ESMA Report Highlights Funds’ Rising Use – and Potential potential issues may arise in connection with voting rights Impact on Market Stability – of Synthetic Leverage From and information flow. Banks are frequently sensitive to Derivative Instruments” (Sep. 15, 2016). surrendering voting control around certain key events, including default remedies and enforcement rights which may Cost-Effective and Operationally Efficient Structure impact the value of the reference assets and increase risk for the bank.
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