On 3 February 2022, the European Securities and Markets Authority (“ESMA”) published the third annual statistical report on EU Alternative Investment Funds (“AIFs”) (the “Report”),[i] providing significant information on the AIF industry and, more particularly, on fund leverage across the various fund structure types.
Compared to 2017 when the International Capital Market Association’s (“ICMA”) Asset Management and Investors Council (“AMIC”) and the European Fund and Asset Management Association (“EFAMA”), in their joint paper of July 2017 entitled “Use of Leverage in Investment Funds in Europe AMIC/EFAMA Joint Paper”, were of the view that leverage in the sector is low, and to 2019 when ESMA issued its first annual statistical report on AIFs, borrowings in the AIF market increased substantially and currently represent approximately 21% (7% in 2019) of the net asset value (“NAV”). The breakdown of borrowing as a percentage of NAV per fund type is as follows: up to 9% (1% in 2019) for funds of funds (“FoFs”); 12% (7% in 2019) for real estate funds (“REFs”); 250% (79% in 2019) for hedge funds (“HFs”); 5% (4% in 2019) for private equity funds (“PEFs”); and 22% (2% in 2019) for other AIFs. The Report points out that the AIF industry is characterised by a significant difference in the use of leverage measured by the ratio of gross exposures to NAV.
The use of leverage by AIFs is now common to most fund sectors. The results of the Report should, however, be analysed while bearing in mind that the data collected did not cover all existing AIFs. Furthermore, according to ESMA, the data may contain errors due to the complexity of the calculation rules and the reporting requirements, including those related to leverage embedded at the individual fund level or at the level of a special purpose vehicle (“SPV”) ultimately held by an AIF. This is particularly true for PEFs. In a typical private equity transaction funded by a leveraged buyout, a shell company (in our case, the SPV) is set up to acquire the target company. The purchase is financed by debt (and equity) and the target company then issues bonds to repay the loans. Despite the potentially high level of leverage involved, under Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers (the “AIFMD”), PEFs (in contrast to other AIFs) do not report leverage at the level of the portfolio companies (no pass-through approach), making it difficult to estimate the actual level of leverage.[ii]
The European Systemic Risk Board’s (“ESRB”) Non-bank Financial Intermediation Risk Monitor (previously Shadow Banking Monitor) 2023[iii] shows that HFs tend to exhibit high levels of leverage that mostly comes from derivatives.
In its Risk Monitor Report, ESMA noted that maturity mismatches persist in commercial REFs and that the impact of the UK gilt market turmoil on leveraged liability-driven investment funds in 2022 confirmed existing concerns about funds’ liquidity risk management and excessive leverage, as well as contagion risks given the strong systemic linkages.[iv]
Leverage can be created either by borrowing money (called “physical leverage”) or assets, such as securities, from financial counterparties (also called “financial leverage”) or by using derivative instruments such as options, futures or swaps (also called “synthetic leverage”). In case of financial leverage, the proceeds of the borrowing are used to reinvest in other assets. Borrowings are registered in the balance sheet of the fund as liabilities. Synthetic leverage is used to mainly manage risks within a portfolio such as exchange rate risks and interest rate risks, but it can also be used to gain exposure to certain assets.
Under the AIFMD, leverage is defined as any method by which the AIF manager (“AIFM”) increases the exposure of an AIF it manages, whether through borrowing of cash or securities or leverage embedded in derivative positions, or by any other means.
Financial leverage at a fund level is also defined as the ratio of total assets to NAV, while the synthetic leverage is referred to as being the ratio of exposures acquired through the use of derivatives to NAV.
Leverage is measured by two different metrics in accordance with Commission Delegated Regulation (EU) 231/2013 of 19 December 2012 supplementing Directive 2011/61/EU of the European Parliament and of the Council, as amended, with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision (the “Level 2 Delegated Regulation”): (i) the gross method, providing information on the total exposures of a fund (in other words, the “footprint” at the individual fund level); and (ii) the commitment method, measuring the leverage as the ratio in between the net exposure of the fund and its NAV. A third method can be employed, the value-at-risk method, which focuses more on the portfolio risks rather than a measure of leverage per se.
According to the Level 2 Delegated Regulation, the gross method calculates the ratio between “the sum of the absolute values of all positions valued in accordance with [the AIFMD]”, (a) excluding the value of any cash and cash equivalents that are highly liquid investments, (b) converting derivative instruments into the equivalent position in their underlying assets, (c) excluding cash borrowings, (d) including exposure resulting from the reinvestment of cash borrowings, and (e) including positions within repo or reverse repo agreements and securities lending or borrowing held by the fund and the fund’s NAV (in other words, leverage is calculated as the ratio between the fund’s investment “gross” exposure and the NAV).
The commitment method calculates the ratio between the net exposure of the fund (without excluding cash and cash equivalents) and its NAV. The commitment method takes into account netting and hedging arrangements. For the calculation, the AIFM needs to: “(a) convert each derivative instrument position into an equivalent position in the underlying asset; (b) apply netting and hedging arrangements; (c) calculate exposure created through the reinvestment of borrowings where such reinvestment increases the exposure of the AIF; and (d) include other arrangements: namely convertible borrowings, repos, reverse repos, securities lending and securities borrowings.”
A sector approach of the Report reveals that FoFs account for 15% of the NAV of AIFs, at around €0.9tn (€770bn in 2019). Typically, their underlying portfolio is composed of equity interests in HFs or PEFs, most FoFs being managed by the same manager. Nevertheless, the Report shows diversified investment strategies of FoFs going beyond portfolios composed of HFs’ and PEFs’ interests, which still represent only 7% (1% in 2019) of the NAV. Considering that FoFs are historically among the main users of NAV facilities, one would have expected to see a higher level of use of leverage for FoFs. Their regulatory assets under management (“AuM”) to NAV equal 145% (115% in 2019) on aggregate and their low leverage levels are mainly due to a limited use of financial and synthetic leverages (less than 1% of NAV).
HFs are, in general, highly leveraged with adjusted leverage at around 330% of the NAV. Such level is due to both synthetic (being a strong component of their investment strategy) and physical leverages. However, direct borrowings dropped from 225% of the NAV in 2019 to only 37% in 2022; this drop is conducted by a drastic reduction in repo and lower short positions. The figures reported to the US Securities and Exchange Commission show qualitative similarities. The Report shows that secured borrowing through repo and reverse repo accounts for 64% of the NAV.
According to the Report, REFs account for 13% (11% in 2019) of the NAV of AIFs, at €766bn (€540bn in 2019), invested mainly in commercial real estate. The industry is concentrated in a few countries. While the synthetic leverage is employed on a marginal side, REFs use financial leverage, being the second largest by AIF type (after HFs), with some of them engaged in short-term borrowings, e.g. subscription lines. The regulatory AuM to NAV is 138% (136% in 2019) on aggregate, with outright borrowing that amounts to 11% (7% in 2019) of the NAV. In addition, the share of unsecured borrowing has jumped from 2% to 5% of the NAV since 2020.
PEFs account for 6% (4% in 2019) of the NAV of all AIFs, or €363bn (€204bn in 2019). PEFs have the lowest use of leverage among the AIF types, with an AuM-to-NAV ratio at 115% (113% in 2019) on aggregate, and very limited use of derivatives and borrowings, representing 2% (2% in 2019) of their NAV. These figures do not necessarily reflect the reality considering that, as explained above, in leveraged buyout transactions, leverage is incurred at the level of the BidCo (the SPVs acquiring the target company) rather than at the level of the fund itself.
While no specific date is provided with regard to debt funds, falling by default within the category of other AIFs, it is established that financial leverage is used as part of the investment strategy.
To understand these figures, it is important to understand what true leverage at the fund level is and what the possible limitations are.
Leveraged facilities, or NAV facilities (also referred to as “asset-backed” facilities), are loans provided to the fund itself, or at a level below, to an SPV. Unlike subscription facilities, leveraged facilities are put in place at a later stage of the fund’s life, immediately after the fund’s close, for a long-term period. The aim is to supply liquidity needs of the fund, notably after the acquisition of the investments when the portfolio becomes illiquid or as a leverage tool. The leveraged facilities are secured by the underlying portfolio and the related distributions. The borrowing base is calculated on the NAV of “eligible” underlying assets.
Specific criteria of the “eligible” underlying portfolio are established by the lenders and include, among others, particular types of assets and geographic and industry sector limitations. A strong component of such financing is the loan-to-value (“LTV”) ratio, meaning the ratio of outstanding loans under the NAV facility to the borrowing base, as adjusted from time to time. The security package focuses on the underlying assets and can be structured either at the level of the fund itself or, more commonly, at the level of the SPV(s). It will include, for example, a pledge over 100% of the equity interests of the fund in the SPV, holding in return the underlying portfolio and the SPV’s bank accounts where the distributions are made, as a portfolio investment payment.
Leverage techniques used by funds are an integral part of their investment strategy. Their aim is to optimise investment returns and improve asset allocation and portfolio diversification. Using leverage in various proportions, depending on the nature of the underlying asset, enables funds to increase their net equity multiple. This benefits investors from two perspectives: (i) a higher return; and (ii) greater investment diversification opportunities. Given current market conditions, funds are now tending to tailor their borrowing to their short- or medium-term needs and to their actual (as opposed to target) size, using contractual techniques to further increase (or decrease) the size of their borrowings. This approach also enables funds to manage more efficiently the cost of borrowing and the fees charged by lenders.
Various metrics are used to measure the impact of leverage on the fund’s performance or on a given transaction. The most common would be the internal rate of return (“IRR”), which measures the monthly portfolio performance. An unleveraged IRR measures the cash flow that the business would be expected to generate had the asset been acquired with 100% equity only. While the leveraged IRR takes into consideration the leverage from debt financing to measure the performance of the underlying asset, the IRR is considered a market standard performance indicator. It has, however, recently faced rising criticism, notably regarding “on-the-paper” inflated performance, which some investment managers have been using to achieve IRR thresholds, triggering, in return, higher incentive awards.
Within the context of a “true leverage” operation, it is more interesting to look at the net multiple or investment multiple, which provides performance information with regard to the fund, rather than at the IRR. This shows the total value as a multiple of its cost basis. For example, in case of the acquisition of a real estate asset for a purchase price of €50m, financed by a ratio of equity to external debt of 40/60 and an unleveraged IRR of approximately 7%, the net multiple increases from 1.5 to 1.7, while the leveraged IRR would equal approximately 10%. In the same line, a deal structured, for example, on the basis of external debt equal to a 60% LTV and a 40% equity-to-mezzanine debt, with 5% equity and 35% mezzanine debt provided by the investors, a 7% IRR calculated in year one would amount to 10.5% in year six. This is a 350-basis-points increase. The operation would generate an exit multiple of approximately 19 and a return of equity of around 10% with, again, a profit of around 1.7.
Regulatory limitation
The existing EU regulatory framework addresses systemic risk concerns. Unlike investment funds subject to Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (the “UCITS Directive”), where the borrowing is strictly limited in respect of the amount and purpose – to 10% of the assets for liquidity needs translated on a temporary basis, and 10% of the assets for financing the acquisition of a real estate property necessary to the pursuit of its business, and on a cumulative basis not exceeding 15% of the total assets in Luxembourg – AIFs are less restricted in their borrowings. Similarly, the recently modernised European Long Term Investment Fund (“ELTIF”) may borrow cash provided that such borrowings fulfil the following cumulative conditions: (a) it represents no more than 50% of the NAV of the ELTIF in the case of ELTIFs that can be marketed to retail investors, and no more than 100% of the NAV of the ELTIF in the case of ELTIFs marketed solely to professional investors; (b) it serves the purpose of making investments or providing liquidity, including to pay costs and expenses, provided that the holdings in cash or cash equivalent of the ELTIF are not sufficient to make the investment concerned; (c) it is contracted in the same currency as the assets to be acquired with the borrowed cash, or in another currency where currency exposure has been appropriately hedged; and (d) it has a maturity no longer than the life of the ELTIF. When borrowing cash, an ELTIF may encumber assets to implement its borrowing strategy.
Additional restrictions may come from national regulations governing the overall supervision or national regulators such as central banks. In November 2022, the Central Bank of Ireland imposed leverage limits on REFs by limiting their recourse to borrowing to a maximum of 60% of total assets. ESMA is supportive of this type of initiative. In Luxembourg, there is no restriction on leverage either in the legal framework or in the Commission de Surveillance du Secteur Financier (“CSSF”).
According to article 111 of the Level 2 Delegated Regulation, leverage is considered to be used on a “substantial basis” when the exposure of an AIF, as calculated according to the commitment method, exceeds three times its NAV, triggering as such an extended disclosure information obligation for the AIFM, in accordance with article 24(4) of the AIFMD to the competent authorities of its home Member State. De facto, this becomes a limitation.
The AIFMD requires AIFMs to “set a maximum level of leverage which they may employ on behalf of each AIF they manage as well as the extent of the right to reuse collateral or guarantee that could be granted under the leveraging arrangement, taking into account, inter alia: (a) the type of AIF; (b) the investment strategy of the AIF; (c) the sources of leverage of the AIF; (d) any other interlinkages or relevant relationships with other financial services institutions, which could pose systemic risk; (e) the need to limit the exposure to any single counterparty; (f) the extent to which the leverage is collateralized; (g) the asset-liability ratio; (h) the scale, nature and extent of the activity of the AIFM on the markets concerned”. Furthermore, “the AIFM should demonstrate that the leverage limits for each AIF it manages are reasonable and that it complies with those limits at all time”. The level of leverage employed must then be monitored and periodically disclosed to investors.
According to ESMA’s Q&A on the application of the AIFMD, an AIFM should calculate the leverage of each AIF that it manages (i.e. the leverage employed at the level of the AIF, including any exposure of a legal structure controlled by such AIF that has been specifically set up to increase, directly or indirectly, the exposure of the AIF) as often as it is required to ensure that the AIF is capable of remaining in compliance with leverage limits at all times. The current level of leverage used of a fund is disclosed in the annual report of each financial year.
In addition, when calculating the leverage of an AIF, an AIFM must take into account the exposure contained in financial or legal structures involving third parties controlled by the AIF, if these structures are specifically set up to directly or indirectly increase the exposure at the level of the AIF. For example, direct or indirect leverage at the level of an AIF investing in real estate is created by financial or legal structures involving third parties (e.g. SPVs controlled by the AIF) that are set up to acquire real estate assets and obtain leverage for that purpose.[v]
It should be noted that temporary borrowing is to be excluded when it is fully covered by the capital calls from the investors. In other words, subscription line facilities are not part of the leverage calculations and reporting.
Strategy limitation
While leverage creates opportunities to increase the total return on investments, it can also potentially increase losses. Although not mandatory from a regulatory perspective, funds will have a leverage limitation imposed by the fund documentation, reflecting the investment strategy and the general consensus among investors or potential investors. The limited partnership agreement (the “LPA”) would generally provide, in a borrowing section linked to the purpose investment strategies and restrictions, rules regarding the fund’s authorisation to use external financing. The general terms may include the possibility for the fund to borrow, trade on margin, utilise derivatives and otherwise obtain leverage from banks and others, on a secured or an unsecured basis.
In a leverage-oriented investment strategy, the overall leverage of the fund or a sub-fund (in case of an umbrella structure) will depend on the investment strategies employed by the AIFM in respect of the fund or sub-fund and specific market opportunities. In an umbrella structure, the leverage limitations will vary from one compartment to another. Limitation for investment purposes can range from a maximum that can be employed in connection with the fund’s investment programme, calculated in accordance with the AIFMD’s gross method and commitment method of the fund’s NAV, e.g. from 300% of the NAV or below (which is the maximum level before the substantial basis qualification) to no external leverage foreseen at all.[vi] Depending on the type of investors and/or the geographical area the fund is sought to be marketed to, the leverage and borrowing levels may be lower or inexistent. Internal leverage may or may not be permitted, meaning that in the latter case, no shareholder loans are allowed.
For example, insurance companies subject to Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (“Solvency II”) invest in unleveraged funds. For the qualification of leveraged vs unleveraged, insurance companies refer to the Level 2 Delegated Regulation. In a letter addressed to the European Insurance and Occupational Pensions Authority in 2018, ESMA declared its view that AIFs that use borrowing arrangements that comply with the criteria set out in article 6(4) of the Level 2 Delegated Regulation, namely temporary in nature and fully covered by contractual capital commitments from investors in the AIF, should be considered unleveraged.
The qualification of leveraged vs unleveraged will then be the main refrain for lenders to provide true leverage financing to funds. While capital call facilities are expressly excluded from the leverage qualification for reporting purposes, there is no legal definition of what “short-term” borrowing is. It is commonly accepted in the European market that all loans with a maturity below or equal to 364 days would correspond to the criteria of a temporary financing.
Limitation of true leverage can further come through external regulations not applicable to the fund but to certain investors and lenders. Insurers, for instance, have limited options to invest in certain kinds of assets, in units of certain AIFs, due to Solvency II, which provides for a number of requirements for insurers, particularly in respect of capital requirement and risk monitoring. Credit institutions such as banks also have regulatory requirements to comply with pursuant to Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (“CRD IV”). Investors and lenders may, in addition to those external regulations applicable to them, have specific internal regulations that may have an impact on the conditions under which they, respectively, invest and lend money to AIFs.
Private banks, or other agents such as family offices, may act for an investor or a pool of investors pursuant to a management mandate, which may contain a certain number of investment restrictions, having the effect of limiting the leverage ratio of a borrower.
In practice, those regulations result, in the case of insurers willing to invest in debt funds, in specific structuring scenarios and limitations to be included in the offering documents. For banks, the LTV is one of the expressions of such limitations, i.e. indebtedness on the fund level to the value of assets, within the context of a financing transaction. This also means that two concurrent financings of the fund of two separate assets may limit reciprocally or incidentally, although the limit imposed by the LPA would not have been reached otherwise.
From another practical perspective, when financing a fund through a NAV facility, lenders generally need to run significant due diligence on the fund’s portfolio. This is especially the case in debt portfolio acquisitions. As the financing also covers future acquisitions and investments that fall within the eligibility criteria, ongoing due diligence is necessary. Extended to hybrid facilities, lenders’ due diligences are even more complex and require the involvement of several teams, and smooth coordination between them.
According to the data provided in the Report, the leverage level has increased in all sectors. AIFs subject to the AIFMD show a large dispersion of leverage. This leads to the conclusion that there are nevertheless many more opportunities for growth in the sector.
We note an increased appetite, on both the debt fund and lender sides, for true leverage financing. Despite a higher interest rate market and competitive financing terms, the appetite of funds for leverage is still here, making it a pre-eminent part of the investment strategy. Nevertheless, in the current market conditions, borrowers are showing a certain degree of caution and are looking for smaller loans to suit their type or medium-term needs.
Furthermore, the overall success of a leverage transaction, within this context, implies a growing interest in and use of derivatives to mitigate interest rate risks. In practice, this is translated by the development of new strategies and products, with an important focus on the development of hybrid solutions, such as capital call arrangements converted after a ramp-up period, in asset-backed borrowings.
Endnotes
[i] ESMA50-165-748. The Report is based on a set of the Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers (the “AIFMD”) data reported by the managers to national authorities and to ESMA and presents the EU AIF market at the end of 2017, https://www.esma.europa.eu/sites/default/files/library/esma50-165-1948_asr_aif_2022.pdf
[ii] ESMA Risk Monitor Report.
[iv] ESMA50-165-2438: ESMA Report on Trends, Risks and Vulnerabilities, No. 1, 2023.
[v] ESMA34-32-352: Questions and Answers – Application of the AIFMD.
[vi] Different limitations would apply for bridge financing, in the case of subscription lines where the authorised amount of borrowing is linked to the capital call commitments available (15% to 25% – according to the ILPA Principles 3.0 2019, the limit should be 20%) and short-term borrowings for management purposes to, for example, satisfy redemption requests in open-ended funds (generally 10% of the net assets, which basically echoes the limitations imposed by the UCITS Directive to UCITS).
I'm an expert in financial markets, particularly with a deep understanding of alternative investment funds (AIFs) and their use of leverage. My knowledge is grounded in a thorough comprehension of the European Securities and Markets Authority (ESMA), International Capital Market Association (ICMA), and European Fund and Asset Management Association (EFAMA) reports, as well as the regulatory framework outlined in Directive 2011/61/EU of the European Parliament and of the Council.
In the article you provided, several key concepts related to the use of leverage by funds are discussed. Let's break down the main concepts:
1. Statistical Reports on Leverage in AIFs
- Overview: ESMA published its third annual statistical report on EU Alternative Investment Funds (AIFs) in 2022.
- Trends: Borrowings in the AIF market increased substantially to approximately 21% of the net asset value (NAV) from 7% in 2019.
- Fund Types: Leverage percentages differ across fund types: FoFs (up to 9%), REFs (12%), HFs (250%), PEFs (5%), and other AIFs (22%).
2. What is Leverage?
- Definition: Leverage can be physical (borrowing money or assets) or financial (using derivatives). Synthetic leverage is used for risk management or exposure to certain assets.
- AIFMD Definition: Leverage, under the AIFMD, includes any method by which the AIF manager increases the exposure of an AIF.
3. How is Leverage Measured?
- Metrics: Leverage is measured using the gross method (total exposures) and the commitment method (ratio of net exposure to NAV). The value-at-risk method is also mentioned.
4. Sector Approach
- FoFs: Account for 15% of NAV, with low leverage levels due to limited use of financial and synthetic leverages.
- HFs: Highly leveraged (around 330% of NAV) with both synthetic and physical leverages.
- REFs: Use financial leverage, second largest by AIF type, with some engaged in short-term borrowings.
5. Leveraged Facilities for Funds
- Definition: Leveraged facilities or NAV facilities are loans provided to the fund or an SPV after the fund's close.
- Criteria: Eligible underlying portfolio and loan-to-value (LTV) ratio are crucial criteria for leveraged facilities.
6. Why is Leverage Used by Funds?
- Investment Strategy: Leverage is used to optimize returns, improve asset allocation, and enhance portfolio diversification.
- Metrics: Internal rate of return (IRR), net multiple, and investment multiple are used to measure the impact of leverage.
7. Limitation of Leverage
- Regulatory Limitation: AIFMD sets limits on leverage, and ESMA requires AIFMs to periodically disclose the leverage used.
- Strategy Limitation: Fund documentation and limited partnership agreements impose limitations on leverage.
- External Limitations: External regulations (e.g., Solvency II for insurers) and internal investor regulations may further limit leverage.
8. External Limitations to Funds
- External Regulations: Insurers, banks, and investors may have specific regulations influencing their investment decisions and limiting leverage.
9. Conclusion
- Trends: The report indicates an increased level of leverage in all sectors of AIFs.
- Opportunities: Despite market conditions, there is still an appetite for leverage, with a focus on caution and smaller loans.
In summary, the article explores the use of leverage in AIFs, its measurement methods, regulatory and strategic limitations, and the impact of external factors on fund leverage. It provides a comprehensive overview of the current landscape in the context of EU regulations and market trends.
