Traditional forms of financing – such as cash prime brokerage, securities lending and plain-vanilla repurchase agreements (repos) – continue to account for a large portion of the financing made available to private funds and asset managers. These types of financing arrangements, however, tend to be available only for more liquid assets, including equity securities and bonds, and are generally either callable on demand or committed for a short period of time, usually not exceeding six months. The leverage available on a fund's underlying assets may also be limited by regulatory constraints and capital considerations, especially those applicable to broker-dealers. As funds seek to use greater leverage; finance esoteric, illiquid assets; and obtain financing on a more committed and longer- term basis, bespoke financing arrangements have become increasingly popular.
Although many of these tailored products are highly specialized and unique to an asset class or financing objective, a large proportion of esoteric financing can be categorized into three buckets:
- total return swap (TRS) financing;
- structured repo financing; and
- special purpose vehicle/entity (SPV) financing.
This article, the first in a two-part series, reviews the main features of TRS financing, and highlights the comparative advantages and disadvantages to private funds of using this structure, taking into consideration the flexibility, the
complexity of the legal documentation and the level of asset protection afforded by the structure. The second article will provide a comparative overview of structured repo financing and SPV financing transactions.
For further discussion of financing available to private funds, see "Types, Terms and Negotiation Points of Short- and Long-Term Financing Available to Hedge Fund Managers" (Mar. 16, 2017); and"How Fund Managers Can Mitigate Prime Broker Risk: Preliminary Considerations When Selecting Firms and Brokerage Arrangements (Part One of Three)" (Dec. 1, 2016).
How to Structure a Total Return Swap
Entering Into a TRS
A TRS is a derivative contract between the fund and a swap dealer (a bank) to exchange the return of the underlying (reference) assets that are being financed through the TRS.
At inception of the TRS, the bank providing the financing will purchase the underlying assets either from the fund or from a seller of those assets in the primary or secondary market. The bank will either hold the assets directly or set up a separate special purpose entity (SPE) to hold those assets. An SPE structure may provide tax, operational, accounting and control (i.e., voting) benefits to the parties that will ultimately be advantageous to the fund.
TRS Economics
In connection with the bank's purchase of the assets, the fund will generally provide some cash collateral in the form of initial margin, which is also referred to as an "independent amount" in swap nomenclature and constitutes a financing"haircut" on the underlying assets. The bank will typically use that initial margin to fund the acquisition of the assets, but the fund may request that the bank segregate the initial margin to provide greater protection to the fund in the event that the bank fails.
The bank will then pass the economics of the reference assets through to the fund in exchange for the fund paying a financing charge on the amount initially used by the bank to purchase the assets, as well as costs incurred by the bank in purchasing, maintaining and administering the assets. Those cash flows are netted and exchanged by the parties, typically on a monthly or quarterly basis.
For more on asset segregation for derivatives, see "EMIR Offers Three Models of Asset Segregation to Fund Managers That Trade OTC Derivatives" (Apr. 16, 2015); and"A Practical Guide to the Implications of Derivatives Reforms for Hedge Fund Managers" (Jul. 25, 2013).
When the TRS is terminated, either (1) partially because one 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 whole at maturity of the TRS facility, the value of the reference assets will be measured (usually through a sale auction of the reference assets carried out by the bank). The fund will receive from the bank any appreciation in the value of the reference assets during the life of the TRS, or conversely, the fund will pay any depreciation in value to the bank.
The transaction will also be marked to market daily based on the value of the reference assets, and margin will generally be posted by both parties in light of the requirements imposed by the newly enacted uncleared swap margin regulations (unless the bank insists on one-way margining, for instance via a commensurate initial margin offset mechanism). In most cases, the amount of margin requested by the bank may be disputed by the fund, in which case the bank will request quotes from third-party dealers making a market in the reference assets, and the margin will be based on quotations provided by those dealers.
See our two-part series on the new swap-margin rules: "Hedge Funds Face Increased Margin Requirements" (Feb. 18, 2016); and"Hedge Funds Face Increased Trading Costs" (Feb. 25, 2016).
See also "Steps Hedge Fund Managers Should Take Now to Ensure Their Swap Trading Continues Uninterrupted When New Regulation Takes Effect March 1, 2017" (Feb. 9, 2017).
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
