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Hedge Funds Fried Frank NAV Triggers
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  © 2009 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 2, No. 4edition of the Bloomberg Law Reports - Risk & Compliance. Reprinted with permission. The views expressed herein arethose of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports (R) is a registeredtrademark and service mark of Bloomberg Finance L.P Trading Agreements and NAV Termination Triggers – AvoidingUnexpected Landmines Contributed by David S. Mitchell, William C. Thum, Aaron S. Cutler and Eduardo Ugarte II, Fried,Frank, Harris, Shriver & Jacobson LLP   Counterparty credit and documentation risk, historically relatively mundane and technicalsubjects, have received ever-increasing investor focus given the tumultuous market events of thelast two years. For hedge fund managers, as well as their dealer counterparts, losses oninvestments and escalating redemptions have proven once again the need to devote significantattention to the analysis, negotiation and tracking of trading agreement terms in order to avoidany unexpected minefields to be found therein.   In an effort to maintain liquidity while addressing their exposure to dealer credit risk, managershave pursued the twin goals of tightening protections against dealers and at the same timeworking to avoid potential landmines related to ever declining net asset values (NAVs or NAV).Once thought to be relatively straightforward, trading agreement termination triggers related toNAV declines have proven challenging in view of the lack of consistency and the unexpectedconsequences of expansive cross-default clauses. Insulating funds from liquidity pressurescaused by such triggers, while at the same time pursuing more aggressive credit terms withdealers, has required a deep understanding of the workings of trading agreements and relateddocuments, and nuanced drafting and negotiation skills.   In the face of declining fund performance, existing NAV triggers have received close scrutiny andhave generated a host of problems, including poorly worded clauses that don’t track how NAV istypically calculated, a wide variation in approaches across dealers as terms have evolved over time, the unexpected impact of broad cross-default clauses, the complexities of monitoringperformance against such triggers and the difficulties of obtaining waivers once triggers arebreached. Poorly drafted clauses leading to unexpected early terminations of outstandingtransactions can also have a detrimental effect on performance and on investor relations. From adealer perspective, drafting ambiguities can seriously undermine the credit protections expectedto be provided to them by the NAV triggers.   These issues call for greater consistency in approach and drafting, careful attention to relatedcross default clauses and a streamlined method for reaching agreement on waivers of, andamendments to, existing NAV triggers.   What is an NAV Trigger?   Historically, dealers have insisted on adding termination triggers linked to NAV declines to hedgefund trading agreements as a form of early warning with respect to a fund’s continuing ability topay and perform. In the ISDA Master Agreement and related prime brokerage documentation,NAV triggers may allow the dealer to take protective action to reduce exposures to the hedgefund, ranging from calling for additional collateral to closing out trades.   Typically, a fund’s NAV is defined as total assets minus total liabilities. In the most commonformat, NAV triggers are tied to the fund’s results as reported in the monthly NAV statementissued to investors. It is a fairly straightforward way for a dealer to monitor credit risk with respectto its hedge fund counterparties, and can serve to address declines in both fund trading andinvestor sentiment toward the fund.    © 2009 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 2, No. 4edition of the Bloomberg Law Reports - Risk & Compliance. Reprinted with permission. The views expressed herein arethose of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports (R) is a registeredtrademark and service mark of Bloomberg Finance L.P Indeed, investor withdrawals and redemptions can compound already significant NAV declinesarising from poor performance. Although investor redemptions can stem from fading confidencein the fund, they can also relate to more benign factors, such as an investor’s need for liquidity tobuy a house, finance a child’s education, or any number of non-market motivations. It is alsoimportant to consider that a hedge fund may have a flat or improving NAV, even in times of poor performance, if investor subscriptions keep pace with, or exceed, trading losses.   Termination triggers related to NAV are generally added as an Additional Termination Event inthe Schedule to the ISDA Master Agreement and as an event of default in related primebrokerage documentation. Such events are triggered when a fund’s NAV declines below aspecified level over a specified period. NAV triggers have at least four common variables: 1) thedecline threshold; 2) the period during which a decline is measured; 3) the starting and stoppingpoint of such measurement; and 4) the NAV components measured.   In a basic example, an event triggered by a 30% decline in NAV in a one-month period isbreached if the fund's current month-end NAV reflects a decline from the fund’s prior month-endNAV of at least 30%, i.e., a $10,000,000 hedge fund has declined to $7,000,000.   Problems with NAV Triggers   NAV triggers used in trading agreements across dealers present a tremendous diversity inapproach. Examples include NAV triggers that measure fund performance at periodic intervals(e.g., one-month, three-months or twelve-months); from a high-water mark; against the prior calendar/fiscal year-end; and/or against an overall floor. NAV components measured mayaddress trading performance only, or may include the impact of investor redemptions,withdrawals and/or subscriptions.   In addition, typical cross-default clauses are used to import termination triggers (including NAVtriggers) specified in other agreements, whether between the parties or involving third parties.Dealers insist on such clauses to level the playing field by taking advantage of better termsagreed to by the fund with other dealers. Depending on the scope of the clauses, they caneffectively serve to reduce such triggers to the lowest common denominator agreed to by a hedgefund with other dealer counterparties.   Period-end NAV triggers vs. Any-day NAV triggers   To test if a fund’s NAV has breached a trigger, at least two starting points for the test are possibleincluding 1) a prior  month-end NAV level (Period-end NAV trigger) or 2) a prior NAV level on anyday (Any-day NAV trigger) - such as the highest NAV level achieved during the relevant timeperiod. Similarly, the end point of the test can be 1) the current month-end NAV level or 2) thecurrent NAV level on any day .   For example, a three-month Period-end NAV trigger tests the current month-end NAV against themonth-end NAV level of the third previous calendar month. A three-month Any-day NAV trigger may test the current NAV against the highest NAV achieved since the end of the third previouscalendar month.   Whereas the Period-end NAV trigger is relatively straightforward, the Any-day NAV trigger canpresent a number of complexities. At issue is whether the trigger addresses the high pointachieved at a month-end prior to the starting point or that achieved on any day during the relevantperiod. Likewise, the end point could test the NAV level at the current month-end or at any day .    As funds typically report NAV on a month-end basis in a statement distributed to investors,referencing the month-end numbers greatly simplifies the analysis. Given the difficulty associatedwith obtaining reporting with respect to interim (any day) estimates of NAV, and that such  © 2009 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 2, No. 4edition of the Bloomberg Law Reports - Risk & Compliance. Reprinted with permission. The views expressed herein arethose of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports (R) is a registeredtrademark and service mark of Bloomberg Finance L.P estimates may not be prepared in accordance with generally accepted accounting principles,NAV triggers referencing daily NAV, either as a starting or end point, may be unworkable.   Even if interim (any day) estimates are contractually agreed to be actionable, the requirement tocalculate, report and monitor daily performance, while at the same time calculating the impact of redemptions, withdrawals and subscriptions, presents enormous challenges.   Targeting Trading Performance or Investor Activity (or both)    An additional complexity with respect to NAV triggers relates to the components of NAV that aremeasured. The definition of NAV for purposes of the NAV trigger can either 1) include the impactof any investor redemptions, withdrawals and subscriptions or 2) exclude such elements, in eachcase occurring within the measured period.   If the NAV definition in the trading agreement includes redemptions, withdrawals andsubscriptions, then the dealer is testing fund trading performance as well as the impact of investor activity. Effectively, money flowing in and out of the hedge fund to investors is relevant for theanalysis. If the NAV definition excludes redemptions, withdrawals and subscriptions, then thedealer is only testing fund trading performance.   Typically, tests only targeting trading performance are used when evaluating NAV over shortperiods (one, three or even twelve month periods). Tests looking at both trading performance andinvestor activity are generally used over longer periods or with respect to over-all floors.   Imprecise drafting with respect to such variables can produce unexpected consequences.Considerable attention has recently focused on NAV definitions which specifically exclude theimpact of redemptions and withdrawals, but remain silent with respect to subscriptions. While it ispossible the drafters had intended to target trading performance, the drafting suggests a hybridapproach. In such situations, for the purposes of the test, the fund effectively benefits from theaddition of any investor subscriptions during the relevant period while at the same time deductingany investor redemptions and withdrawals.   NAV Floors   NAV floors are used to establish a threshold below which a termination is triggered. Twoapproaches are typically used: 1) a fixed threshold amount (Hard Dollar NAV Floor) or 2) afloating threshold determined through use of a formula (Calculated NAV Floor).    A Hard Dollar NAV Floor is triggered if the fund's NAV declines below the specified floor amount. A Calculated NAV Floor uses a variety of approaches including: tiered floors, floors based on adecline from a year-end NAV level, or floors based on a decline from a high-water NAV levelsince fund launch.   The tiered approach includes a table of NAV values with a corresponding NAV floor threshold.For example, a tiered approach may specify that if the fund's NAV is between $100,000,000 and$300,000,000, the Calculated NAV Floor will be $30,000,000. NAV floors based on year-endNAVs or high-water mark NAVs specify a threshold trigger calculated from the particular startingpoint. 1   Impact of Cross Default Clauses    As noted above, dealers often insist on adding cross default clauses to trading agreements tobenefit from termination triggers agreed to by a fund in other agreements with the dealer and/or inagreements with other dealers.    © 2009 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 2, No. 4edition of the Bloomberg Law Reports - Risk & Compliance. Reprinted with permission. The views expressed herein arethose of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports (R) is a registeredtrademark and service mark of Bloomberg Finance L.P In both the 1992 and 2002 versions of the ISDA Master Agreement, such clauses include DefaultUnder Specified Transactions (DUST) (at Section 5(a)(v)) and Cross Default (at Section 5(a)(vi)).While DUST typically targets defaults involving other derivatives trading agreements between theparties and related entities, the Cross Default clause targets defaults exceeding a thresholdinvolving borrowed money owed to third parties. Similar clauses appear in dealer primebrokerage agreements and elsewhere.   Where the standard ISDA clauses have been amended to include defaults involving derivativetransactions with third parties , NAV triggers occurring in such agreements may be imported tocloseout outstanding trades under the ISDA. Where the ISDA agreements have also beenamended to require parties to provide notices of Events of Default or Potential Events of Default,a fund could find itself obligated to provide Dealer A with notice of its breach of an NAVtermination trigger with Dealer B - even if the NAV trigger agreed with Dealer A has not yet beenbreached.   NAV Trigger Issues and Solutions    Ambiguous drafting, triggers linked to interim (any day) NAV, mixed approaches to theinclusion/exclusion of investor activity and expanded cross default clauses all demonstrate theneed for a greater degree of precision and consistency with respect to the drafting of NAVtermination triggers.    Adding to the complexity is the scenario where different agreements (sometimes with the samedealer) have different definitions of NAV and different NAV termination triggers, so that multiplevariables need to be considered when monitoring triggers against monthly NAV performance.These differences in approach add to the complexity of a fund’s efforts to monitor its tradingagreement NAV triggers as it seeks to maintain its overall liquidity, as well as respond to adealer’s efforts to manage credit risk.   Consistent Terms   While tailored approaches are required in the context of different fund sizes, levels of management expertise, trading strategies, etc., going forward, a more consistent structure interms of drafting, definitions and approach is useful to allow funds to monitor liquidity risks anddealer counterparties to address credit risk more efficiently.   Given that hedge fund NAV is typically calculated on a month-end basis and distributed toinvestors in a monthly statement, references to interim estimates of NAV present serious practicalcomplexities in terms of production and tracking which compromise their utility as actionabletermination triggers. For these reasons only NAV calculated as of the close of business on thelast calendar day of each calendar month should serve as a practical trigger.   More compelling is an approach involving a combination of Period-end NAV triggers including: 1)short-term triggers (e.g. declines over one, three and twelve months) targeting tradingperformance, excluding the impact of redemptions, withdrawals and subscriptions; and 2) overallfloor triggers addressing both trading performance and investor activity, including redemptions,withdrawals and subscriptions.   Great care needs to be given to the drafting of cross default clauses to ensure that where defaultson other derivative transactions are to be imported, the acceleration of the other tradingagreement must be required (and not merely a breach of the NAV trigger in the other tradingagreement). The added requirement for acceleration of the underlying agreement is meant toensure that the termination event merits a serious response. Moreover, it is critical that anappropriate default threshold is specified, preferably based upon the net amount outstanding after acceleration of the other trading agreement (after application of any collateral or other creditsupport) to ensure that only significant defaults are imported.  
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