The Directive states that the employment of leverage by an AIFM may contribute to the “build up of systemic risk or disorderly markets”. It defines leverage as “any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash securities, or leverage embedded in derivative positions or by any other means”. This definition is wide and particularly in light of the calculation methodologies required to be employed the amount of “leverage” employed in a Directive sense is often far higher than borrowing limits which may otherwise be set out in fund documents from a commercial perspective.
Under the Directive, Member States shall ensure that each authorised AIFM shall set leverage limits in respect of each AIF it manages. In the context of the UK, the FCA’s rules on maximum leverage limits are set out in the FCA Handbook (FUND 3.7.7 to 3.7.9) and requires an AIFM which is fully authorised by the FCA to:
As set out in more detail here, an AIFM which is authorised under the Directive or which markets an AIF in the EU is required to make certain disclosures to investors regarding the leverage employed on behalf of the relevant AIF.
Some of these disclosures are required to be made to investors before they invest, and some are required to be made on a periodic basis. In the UK, these rules are contained in the FCA Handbook (FUND 3.2.1(1) and FUND 3.2.6).
Reporting to regulators
In order for the home regulator to identify the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system or risks disorderly markets, an AIFM which is fully authorised under the Directive and that manages an AIF employing leverage on a substantial basis is required to make available to its home regulator information about:
- the overall level of leverage employed by such AIF;
- a break-down between leverage arising from borrowing of cash or securities;
- leverage embedded in financial derivatives;
- the extent to which assets have been re-used under leveraging arrangements;
- the five largest sources of borrowed cash or securities and the amounts of leverage received from each of those entities; and
- any other information required by the home regulator for the effective monitoring of systemic risk.
In the UK, these rules are set out in FUND 3.4.5.
Leverage shall be considered to be employed on a substantial basis when the exposure of an AIF calculated according to the Commitment Method (as described below) exceeds three times its net asset value.
The home regulator shall also ensure that such information is made available to other relevant EU regulators, ESMA and ESRB. In exceptional circumstances ESMA may request that home regulators impose additional reporting requirements.
These rules also apply to AIFMs that market AIFs in accordance with the marketing rules contained in the Directive.
In order to limit the extent to which leverage contributes to the build-up of systemic risk in the financial system or risks disorderly markets, the home regulator is permitted to impose its own limits on the level of leverage an AIFM may employ or other restrictions on management (after having notified ESMA and ESRB). In the UK, the FCA’s powers in this regard are set out in Regulation 68 of the UK Regulations.
In addition, after taking into account the advice of ESRB, if ESMA makes a determination that the leverage employed by an AIFM poses a substantial risk to the stability and integrity of the financial system, it may specify remedial measures to be taken by the home regulators, which include limits on the degree of leverage which the AIFM may employ.
The leverage rules in the Directive are essentially aimed at leverage employed at the level of the AIF. Exposure which is contained in any financial or legal structures controlled by the relevant AIF must be included in the calculation of the exposure where those structures have been specifically set up to increase, directly or indirectly, the exposure of the AIF. However, for the purpose of calculating leverage for private equity funds for example, any exposure that exists at the level of either the relevant financial structure or investee companies should be excluded where the AIF’s or the AIFM’s exposure is limited to its investment in such financial structure or such companies (as applicable). For more detail, see ESMA’s guidance on calculation of leverage here under Section VII in its Q&A.
Additionally, temporary borrowing should be excluded where it is fully covered by capital commitments from investors. It may be worth noting that revolving credit facilities could give rise to borrowing which is not temporary in nature, particularly if utilised on a continually rolling basis.
In calculating leverage, the Level 2 Regulations require:
- AIFMs to employ two methods for calculating the amount of leverage employed: (i) the Gross Method and (ii) the Commitment Method; and
- the overall leverage of an AIF to be expressed as a ratio between the exposure of the AIF and its net asset value (and AIFMs must ensure that investors receive adequate information about these methods in order to avoid confusion over the meaning of reported leverage figures).
When calculating an AIF’s exposure using the Gross Method, AIFMs should:
- exclude the value of any cash and cash equivalents which are highly liquid investments held in the base currency of the AIF that are readily convertible to an amount of cash, subject to an insignificant risk of change in value and which provide a return no greater than the rate of a three month high quality government bond;
- convert derivative instruments (using the conversion methodologies set out in Annex II of the Level 2 Regulations and paragraphs (4) to (9) and (14) of Annex I of the Level 2 Regulations) into the equivalent position in their underlying assets;
- exclude cash borrowings that remain in cash or cash equivalent as referred to in the first bullet point above and where the amounts of that payable are known;
- include exposure resulting from the reinvestment of cash borrowings, expressed as the higher of the market value of the investment realised or the total amount of the cash borrowed as referred to in paragraphs (1) and (2) of Annex I of the Level 2 Regulations; and
- include positions within repo or reverse repo transactions and securities lending or borrowing or other arrangements in accordance with paragraphs (3) and (10) to (13) of Annex I of the Level 2 Regulations.
When calculating an AIF’s exposure using the Commitment Method, AIFMs should:
- convert derivatives positions (using the conversion methodologies set out in Annex II of the Level 2 Regulations and paragraphs (4) to (9) and (14) of Annex I of the Level 2 Regulations) into the equivalent position in the underlying asset, provided certain conditions are met;
- apply netting and hedging arrangements (again, subject to specified conditions);
- calculate the exposure created through the reinvestment of borrowings where that reinvestment increases the AIF’s exposure as defined in paragraphs (1) and (2) of Annex I of the Level 2 Regulations; and
- include other arrangements in the calculation in accordance with paragraphs (3) and (10) to (13) of Annex I of the Level 2 Regulations.
Financial derivatives instruments do not need to be taken into account where they do not provide incremental exposure or leverage. By way of example, where an AIF that invests in an index future contracts and holds a cash position equal to the total underlying market value of such contract, its exposure is deemed to be equivalent to its exposure resulting from a direct investment in the index shares. On that basis, using such a futures contract does not create any incremental exposure.