Fund-level leverage

There are two completely different places a fund's borrowing can sit.

It can sit inside a portfolio company. A buyout target may carry a mountain of debt, and the fund's equity in it is geared as a result. The fund itself has borrowed nothing.

Or it can sit at the fund level. Here the AIF borrows in its own name, often using the securities it has already bought as collateral, and invests the money.

The workbook describes the second one as market borrowing by an AIF at the fund level using its invested securities as collateral. And it says something important about who may do it: borrowing at fund level for the purpose of its investment strategy is unique to Category III AIFs.

So this is the line that separates the categories. Category I and II AIFs may not gear themselves up to invest. Category III may, within limits and with investor consent.

The limit is 2 times the net asset value of the fund. And the NAV used in that test excludes any funds the AIF has borrowed, so borrowing cannot make its own room.

Three chapters carry the rule, and they fit together as a permission, a cap and a disclosure duty.

1. The definition and the category line. Section 15.3 defines it in the reporting context: leverage in this context refers to the market borrowing by an AIF at the fund level using its invested securities as collateral as may be required. Borrowing at fund level for the purpose of its investment strategy is unique to Category III AIFs. Chapter 6's comparison table says the same from the other side — Category II funds seeking later-stage opportunities do not use any leverage at fund level or indulge in complex trading operations, while Category III funds may employ leverage at fund level.

2. What Category I and II may still do. Chapter 17 permits only two narrow things. Category I and Category II AIFs shall not borrow funds directly or indirectly, except for meeting temporary funding requirements:

Separately, to facilitate ease of doing business, Category I and Category II AIFs may borrow to meet a temporary shortfall in the amount called from investors for making an investment — the drawdown amount. That is available only in case of emergency and as a last recourse, when the investment opportunity is imminent and the drawdown has not been received despite the manager's best efforts. The cost of such borrowing is charged only to the delaying investor or investors, and a 30-day cooling off period must be maintained between two periods of borrowing, counted from the date of repayment of the previous borrowing. Category II AIFs may also engage in hedging, subject to SEBI's guidelines.

3. What Category III may do, and the cap. A Category III AIF may take leverage or borrow money for the purpose of investing in the securities market, provided:

• prior consent of investors is taken by the investment manager;
• the maximum leverage does not breach the limits specified by SEBI, which are currently 2 times the NAV of the fund; and
• disclosures are made to investors and SEBI periodically.

Those disclosures must cover four specific things: the overall level of leverage employed, the level of leverage arising from borrowing of cash, the level arising from positions held in derivative contracts, and the main source of leverage in the fund.

4. How the cap is measured.

Leverage = Total exposure {Long positions + Short positions (after offsetting as permitted)} ÷ Net Asset Value

NAV for this purpose is the sum of the value of all securities adjusted for mark-to-market gains and losses, including cash and cash equivalents, and it shall exclude any funds borrowed by the AIF. The leverage ratio is calculated at the scheme level. Where a Category III AIF invests in units of other AIFs, it may take leverage of up to 2 times a NAV that excludes the value of those units.

5. The governance that comes with it. Where a Category III AIF deploys leverage, section 17.10.1 requires it to implement a comprehensive risk management framework with an independent risk management function commensurate with the size, complexity and risk profile of the fund, maintain an independent compliance function, keep records of all trades and transactions available to SEBI, and fully disclose present and potential conflicts of interest with their resolution mechanisms.

Chapter 9's risk-factor disclosure adds the practical instruction: adequate internal controls at the fund level to ensure compliance with the prudential norms, and reporting any breach of leverage limits specified by SEBI, on a monthly basis if the fund is taking leverage.

Three funds from the same house, one question each.

Fund 1 — Sahyadri Growth Fund, a Category II AIF with investable funds of Rs 600 crore. A deal needs Rs 90 crore and only Rs 70 crore of the drawdown has arrived by the closing date.

Permitted — and only as a last recourse for an imminent opportunity. The interest cost is charged only to the investor who delayed, not spread across the fund. The next borrowing cannot begin until 30 days after this one is repaid.

What the fund may not do is borrow Rs 200 crore for three years to buy more companies. That is fund-level leverage for an investment strategy, and it is unique to Category III.

Fund 2 — Sahyadri Long Short Fund, a Category III AIF with an NAV of Rs 400 crore.

It may lever up to 2 times NAV, so a permitted total exposure of Rs 800 crore, provided the manager has taken prior investor consent and makes the four periodic disclosures.

Say it borrows Rs 250 crore of cash and runs Rs 550 crore of derivative exposure after offsetting:

Exactly at the cap. The disclosure to investors and SEBI must break the 800 down — how much comes from borrowing of cash (Rs 250 crore) and how much from derivative positions (Rs 550 crore) — and name the main source.

The trap in the denominator. A manager who added the borrowed Rs 250 crore into NAV would report 800 ÷ 650 = 1.23 times and believe there was Rs 500 crore of headroom left. The rule removes that: NAV excludes any funds borrowed by the AIF.

Fund 3 — Sahyadri Fund of Funds, a Category III AIF with a NAV of Rs 300 crore, of which Rs 120 crore is invested in units of other AIFs.

Its leverage cap is 2 times a NAV that excludes those units:

Not Rs 600 crore. The exclusion cuts the permitted exposure by Rs 240 crore, and it is the single most commonly missed line in this rule.

And what a breach sets off. If Fund 2's exposure marks up to Rs 810 crore on an NAV of Rs 400 crore, leverage is 2.03 times. The fund reports the breach to its custodian by the end of the next working day and to all investors before 10:00 AM the next working day; the custodian reports the name, extent and reasons to SEBI before 10:00 AM the next working day; the fund squares off the Rs 10 crore of excess by the end of that day and confirms to investors; and the custodian confirms the square-off to SEBI the same day.

Chapter 15 (Fund Monitoring, Reporting and Exit), section 15.3, defines fund-level leverage in the reporting disclosures for Category III AIFs. Chapter 6, section 6.3, uses it as a category discriminator in Table 6.1. Chapter 17 carries the rules — sections 17.9.1 and 17.9.3 for the Category I and II temporary borrowing allowance, 17.9.4 for the Category III permission, and 17.10.3 for the prudential cap and formula. Chapter 9's Leverage Risk factor adds the monthly breach reporting.

The single most examinable point is the category line: borrowing at fund level for the purpose of an investment strategy is unique to Category III AIFs. Then the three numbers for Category I and II — 30 days, 4 occasions a year, 10% of investable funds — and the Category III cap of 2 times NAV with prior investor consent. Expect the NAV definition too, because NAV excludes borrowed funds, and the fund-of-funds variant where NAV excludes the value of units of other AIFs.

• Fund-level leverage is not the same as leverage inside a portfolio company. An LBO target may be heavily geared while the fund itself has borrowed nothing. Only borrowing by the AIF counts here.
• Category I and II may borrow, but not to invest. The allowance is for temporary funding requirements — 30 days, 4 occasions a year, 10% of investable funds — and for a drawdown shortfall as a last recourse.
• The drawdown-shortfall cost is charged only to the delaying investor. It is not a fund expense.
• The 30-day cooling off runs from repayment of the previous borrowing, not from the previous borrowing date.
• NAV excludes borrowed funds. Adding the borrowing back into the denominator is the commonest way a candidate and a manager both get the ratio wrong.
• For a Category III AIF holding units of other AIFs, the NAV for the cap excludes those units. So the permitted exposure is smaller, not larger.
• Prior investor consent is a condition, not a courtesy. So is periodic disclosure of the four leverage components.
• The leverage ratio is measured at the scheme level. Not across all schemes of the fund.
• The cap is 2 times NAV, and the workbook says it is what SEBI currently specifies. The regulation says the limits shall be as specified by SEBI from time to time; the 2 times figure is the current one.