Leverage risk

Leverage does not change what a portfolio owns. It changes how much of a move in that portfolio reaches the investor.

The investment manager of a Category III AIF is permitted to take leverage as per the prudential norms set by SEBI, currently two times the NAV of the fund. The workbook's warning is that managers should not take excess leverage, which increases the inherent risk of the fund's investments on account of positions in derivative contracts.

For Category I and II AIFs the position is almost the reverse: no leveraging at fund level is permitted, directly or indirectly, save for narrow temporary borrowing.

Category III. 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, the maximum leverage does not breach the limits specified by SEBI from time to time, and disclosures are made periodically to investors and SEBI covering the overall level of leverage, the level arising from borrowing of cash, the level arising from positions held in derivative contracts, and the main source of leverage in the fund.

Category I and II. No leveraging at fund level, directly or indirectly, except for meeting temporary funding requirements for not more than 30 days, on not more than 4 occasions in a year, and not more than 10% of the investable funds. Category I AIFs are additionally allowed to borrow to meet a temporary shortfall in the drawdown amount called from investors, only in an emergency and as a last recourse where an imminent investment would otherwise be missed — with the cost of such borrowing charged only to the delaying investors and a 30-day cooling off period between two borrowings, counted from repayment of the previous one. Category I and II AIFs domiciled in an IFSC are outside these restrictions, subject to disclosure of maximum leverage and methodology in the PPM, investor consent and a risk management framework.

Two breach clocks, and they are different. The manager must implement internal controls to ensure compliance and report any breach of the leverage limits specified by SEBI on a monthly basis if the fund is taking leverage. Separately, where a Category III AIF breaches its permitted leverage limits, the custodian shall report to SEBI the name of the fund, the extent of the breach and the reasons before 10 a.m. on the next working day.

The workbook's case study is the point of the whole section. Long Term Capital Management had equity of USD 5 billion and borrowings of over USD 125 billion by 1998 — a leverage ratio of 30:1 — because its convergence trades earned miniscule spreads. The Russian sovereign default turned relative-value profits into losses that the leverage multiplied, the fund was forced to liquidate, and the final bailout was USD 3.65 billion.

Godavari Absolute Return Fund, a Category III AIF, has a NAV of Rs 200 crore.

Maximum permitted exposure   2 x Rs 200 crore   =  Rs 400 crore
Actual gross exposure                             Rs 380 crore  (1.9x)

The underlying basket falls 10%.

Loss on Rs 380 crore of exposure                  Rs 38 crore
As a share of NAV                                 19%
NAV falls to                                      Rs 162 crore

An unlevered fund with the same Rs 200 crore would have lost Rs 20 crore and shown a 10% decline. The portfolio was identical; the leverage did the rest.

Now watch the limit break itself, with no trade placed:

New NAV                                           Rs 162 crore
New cap        2 x Rs 162 crore                =  Rs 324 crore
Gross exposure, marked down with the market       Rs 342 crore  (2.11x)

The fund is now in breach because the denominator moved. The custodian must report the name of the fund, the extent of the breach and the reasons to SEBI before 10 a.m. on the next working day, and the manager's monthly leverage reporting continues in parallel.

Against that, a Category II fund with Rs 500 crore of investable funds may borrow at most Rs 50 crore, for at most 30 days, no more than four times a year — enough to bridge a delayed drawdown, and nothing like enough to change the shape of its returns.

Chapter 9 section 9.5 item 12 gives the two-times NAV cap and the monthly breach reporting, with the LTCM case in Box 12.1 of Chapter 12; Chapter 13 section 13.7.2 supplies the custodian's next-working-day 10 a.m. report; Chapter 17 section 17.9 carries the 30-day, 4-occasion, 10% temporary borrowing rule for Category I and II. Expect a numeric cap question and a who-reports-what-by-when question.

• Two times NAV is a Category III rule. Category I and II have no fund-level leverage except temporary borrowing — 30 days, 4 occasions a year, 10% of investable funds.
• Two different reporting duties. The manager reports breaches monthly if the fund is taking leverage; the custodian reports a Category III breach before 10 a.m. the next working day.
• The cap is measured against NAV, which moves. A static position can breach the limit purely because NAV fell.
• Category III leverage needs prior investor consent and periodic disclosure split between cash borrowing and derivative positions.
• Drawdown-shortfall borrowing is charged to the delaying investor, not to the fund, and carries a 30-day cooling off period.
• IFSC-domiciled Category I and II AIFs are carved out of the leverage restrictions, subject to PPM disclosure, investor consent and a risk framework.
• LTCM was 30:1, not 2:1 — the workbook uses it to show what the cap exists to prevent.