UK: Fund Finance 2018

Derivatives At Fund Level

Overview

This chapter considers a number of structural and documentary legal issues to be considered by a fund that is thinking about entering into derivative transactions at fund level. The observations made in this chapter are drawn from experience in the European fund finance and derivatives markets and are not tailored to any particular derivatives strategy. This chapter does not provide detailed legal and regulatory analysis in relation to particular issues by reference to the laws of any particular jurisdiction. Any fund that intends to enter into derivatives at fund level should obtain legal and regulatory advice under the laws applicable to the proposed parties to the transaction and to the transaction itself, which should be tailored to the particular characteristics of the parties, the fund's constitutional documents and the circumstances of the transaction. The international nature of the funds and derivatives markets, and the growing tide of regulation in the derivatives space, means that increasingly this legal and regulatory advice will need to consider laws from multiple jurisdictions.

Introduction

There are a wide variety of reasons why a fund may consider entering into derivatives, but derivative use can generally be split between derivatives of a speculative nature used by a fund to target investment return, and derivatives of a hedging nature which are designed to protect against the economic impact of a particular risk faced by that fund.

Basic examples of risk that a fund may wish to mitigate with derivative use are foreign exchange (forex/FX) exposure (for example, covering the currency exposure for a USD fund that will be drawing USD amounts from investors to fund a particular investment that is denominated in GBP) and interest rate exposure (for example, covering the risk of an adverse movement in interest rates increasing the amount required to be paid on borrowings made by the fund). For some funds, FX and interest rate hedging will be all that the derivative strategy needs to cover. At the other end of the spectrum, funds that use derivatives in the active pursuit of investment return can be expected to enter into a wide array of sophisticated derivative instruments.

Sometimes a fund's exposure to a particular risk is indirect and it is more appropriate for the relevant derivative to be entered into below fund level. A common example in the private equity fund space is interest rate hedging for an acquisition finance facility. The buyer under the relevant acquisition transaction will be a vehicle set up by the fund to make the acquisition. It is this vehicle that would enter into any acquisition finance facility to assist in funding the acquisition. Consequently, it is this vehicle that is directly subject to any interest rate fluctuations on that facility; the fund is only indirectly exposed through its ownership of the vehicle. As such, it is this vehicle, not the fund that would enter into a derivative to hedge the interest exposure on the acquisition finance facility. The lenders under the acquisition finance facility expect to see this derivative in place, in the acquisition vehicle, as an important part of their protections against a payment default. They know that, if interest rates increase, their borrower will have the benefit of the derivative to help fund the increased interest payments that it owes to them. It would not make sense for the lenders if this derivative were entered into at the private equity fund level. The benefit of the derivative would be in the wrong place.

The legal issues considered in this chapter are potentially relevant in respect of any derivative use by a fund.

Potential advantages and disadvantages of entering into derivatives at fund level

Any fund deciding whether or not it should enter into derivatives at fund level will need to consider its specific circumstances carefully. In addition to legal considerations, it will want to understand the accounting treatment, regulatory consequences and tax impact of the derivatives. It will also want to consider the operational impact of the derivatives upon the fund.

Potential advantages of entering into derivatives at fund level

The primary benefit of entering into a derivative at fund level is, of course, that the fund will have the direct benefit of the derivative and the potential return, or risk protection, that the derivative provides. Where a particular risk directly affects a fund, it may not be commercially possible to hedge that risk at anywhere other than the fund level.

The fund may also be able to obtain better pricing for the relevant derivative by entering into it directly rather than via a fund-owned vehicle. The counterparty to the derivative may welcome the financial strength and risk profile of the fund, as that will enable it to enforce its rights directly against the fund.

The taxation treatment of the derivative may be better if the derivative is entered into at fund level rather than in an investment vehicle owned by the fund. This will depend upon the tax rules applicable to the structure.

Having an agreed derivatives platform (for example, having International Swaps & Derivatives Association (ISDA) Master Agreements and Schedules negotiated and signed with one or more counterparties) at fund level means that the fund can enter into multiple derivative transactions using the same centralised documents, rather than having the cost, complexity and delay of negotiating bespoke documentation – as would be required if each new derivative were instead to be entered into, on a case-by-case basis, by separate investment vehicles owned by the fund.

Potential disadvantages of entering into derivatives at fund level

There are possible disadvantages, however, for a fund in entering into derivatives directly. Although derivatives are entered into with the intention of increasing performance or mitigating risk, they often carry a downside exposure which the fund must manage.

The fund must monitor any permissions required under its constitutional documents to ensure that its use of derivatives does not fall outside its powers. This may be operationally burdensome, depending upon the scope of any such requirements. Permissions requirements are considered in more detail later in this chapter.

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Originally published in Global Legal Insights

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.