By Fabien Carruzzo and Dan King from US law firm Kramer Levin
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 mainly for liquid assets, such as equity securities and bonds, and are generally either callable on demand or committed for a short period of time. The leverage available on a fund’s underlying assets may also be limited by regulatory constraints and capital considerations. 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. Two such products are total return swaps (“TRS”) and structured repos.
Total Return Swaps
At inception of the TRS, the party providing the financing will purchase the underlying assets either from the counterparty or from a seller of those assets in the primary or secondary market. In connection with the purchase of the assets, the party receiving financing will generally provide cash collateral in the form of an independent amount which constitutes a financing “haircut” on the underlying assets. The economics of the reference assets are then passed through to the party receiving financing in exchange for the payment a financing charge. Those cash flows are netted and exchanged by the parties periodically, typically monthly or quarterly.
When the TRS is terminated, either partially (because one of the reference assets pays down or is sold) or in whole at maturity of the TRS facility, the value of the reference assets will be measured (usually via a sale auction for the reference assets) and a payment will be made by the relevant party reflecting any appreciation or depreciation in value of the reference assets. The transaction will also be marked to market daily based on the value of the reference assets and margin will typically be posted by both parties.
TRS transactions are documented using the ISDA documentation architecture, including the credit support annex for margining, customized by deal-specific confirmations. TRS financings are highly customizable and can be built to provide for commitment terms with respect to reference assets and certain asset and portfolio eligibility criteria designed to mitigate concentration and other risks incurred by the party providing the financing.
Other features, very typical of financing arrangements, such as make-whole amounts and unused line fees payable by the fund to the bank in the event of an early termination of the TRS facility. Also, voting rights and information flow for reference assets requiring active management can be customized to ensure the fund retains most of the attributes of ownership without jeopardizing the characterization of the transaction as a swap.
- The synthetic structure does not require a party seeking financing to fully fund the acquisition of the reference assets. Moreover, for restricted assets or where confidentiality is a key consideration, a synthetic purchase allows exposure to the reference assets without appearing as the registered owner of the reference assets.
- TRS transactions have flexible documentation, economics and overall transaction management. TRS can be structured to achieve a number of economic goals such as maturity manipulation (e.g. TRS facility providing for a total return on the reference assets at a date prior to the maturity of the assets), achieving desired haircuts through negotiated initial margin and fixing returns. Payment netting under the ISDA master agreement also enables both parties to structure the cash flows to minimize operational and counterparty risk.
- Swaps benefit from a broad Bankruptcy Code safe harbor protection enabling the party providing financing to terminate and liquidate the transaction and the underlying assets typically held as a hedge immediately upon default by the fund without being subject to a bankruptcy automatic stay.
- Given the reference assets are generally held by the party providing financing, the lack of title to the reference assets may be an issue if the reference assets are distressed and/or require active management. In addition, in cases where the party providing financing holds the assets and has a commercial relationship with the reference entities it is possible that its interests may diverge from those of the TRS counterparty.
- Settlement typically occurs utilizing a cash settlement mechanism where the value of reference assets is measured upon maturity of the TRS financing and capital appreciation or depreciation payments are made by the parties. This may limit the fund’s ability to recover the assets at maturity.
- There is counterparty credit risk for any initial margin posted and for any other amounts accrued but unpaid by the party providing financing under the TRS, such as income generated by the reference assets and any capital appreciation, to the extent those amounts are not timely supported by variation margin.
A repo, or repurchase agreement, combines the outright sale of an underlying asset by a seller to a buyer with an agreement by the seller to repurchase the same underlying asset from the buyer at a future date.
At inception of the repo, the party providing the financing will purchase the underlying assets from the counterparty or from the primary or secondary market on behalf of the seller. The buyer may hold the assets on its books or rehypothecate them to raise the necessary financing from the market. The assets are typically purchased at a haircut to the market value reflecting their risk profile, with the haircut providing some credit cushion to the buyer for the financing provided under the repo, much like initial margin in a TRS.
Similar to a TRS, the economics of the reference assets are then passed through by the buyer to the seller, with the seller paying a financing charge, based upon the purchase price of the reference assets. When the repo is terminated, either partially or in whole, the assets are bought back by the original seller at a predetermined repurchase price. In the event that the financing is unwound early or is otherwise terminated due to a failure to satisfy commitment terms, the repurchase price will typically reflect a premium to compensate the buyer for lost profits on the financing.
As with TRS, structured repos will be marked to market and margined daily based on the value of the reference assets and margin will be posted at least by the recipient of the financing.
Structured repos are generally documented on the MRA/GMRA infrastructure, with the master being customized through annexes and bespoke confirmations to reflect features such as commitment terms, margin and valuation, limitations on eligible reference assets and voting/information control.
- Repos on certain reference assets including mortgage loans and securities and otherwise satisfying certain criteria benefit from Bankruptcy Code safe harbor protections enabling liquidation without being subject to foreclosure restrictions.
- Ability by the recipient of financing to effectuate physical settlement and recover the reference assets at maturity of the repo. This increased certainty of recovering title to the reference assets makes structured repos useful for bespoke assets intended to be retained and managed post-termination of the financing.
- Although the outright sale of the reference assets has its benefits, there are also drawbacks to the transfer of title. Pass-through of voting rights and limitations on the buyer’s ability to rehypothecate the reference assets may adversely impact the availability of the Bankruptcy Code safe harbor protection.
- The title transfer nature of a structured repo also brings into play any asset transfer formalities and/or restrictions in the reference assets, both at the purchase date and the repurchase date. As a result, structured repos are typically more effective where the referenceassets are freely transferable with limited operational constraints.
- The Bankruptcy Code safe harbors for “repurchase agreements” and “securities contract” that cover structured repos are also significantly narrower than the safe harbor for "swap agreement" on which TRS transactions rely. Specifically, the safe harbors limit protection to transactions where the underlying reference assets are “securities” or “mortgage loans” and provide for certain other limitations relating to the maximum tenor of protected transactions and market participants entitled to rely on the safe harbors.
Fabien Carruzzo leads Kramer Levin’s nationally recognized Derivatives and Structured Products group. He provides counsel on the full spectrum of transactional and regulatory derivatives matters, covering a wide range of equity, credit, currency, commodity, fund and fixed income derivatives.
Daniel King works with clients on both transactional and regulatory matters. He advises on a variety of derivatives, structured products, swap financings and structured finance transactions.
Kramer Levin is an Am Law 100 firm with offices in New York, Silicon Valley and Paris.