NAV trigger
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Negotiation Anatomy™
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The right to terminate a master agreement as a result of the decline in net asset value of a hedge fund counterparty (other counterparty types generally won't have a “net asset value” to trigger).
Often there are three levels of trigger: Monthly; Quarterly and Annually. You may find yourself embraced in a tedious argument about whether these should be “rolling” (that is, judged for the period from any day) or “point-to-point” (that is, judged from a defined day to the end of the period following that day).
Like most events of default, NAV triggers are a second-order derivative for the only really important type of default: a failure to pay. A significant decline in NAV makes a payment default more likely. NAV declines in three main ways:
- The value of assets (be they physical or derivative) declines
- The cost of financing those assets - the leverage - increases
- Investors withdraw money from the fund.
Prime brokers hold initial margin to protect against the first, control the second in any weather, and one would expect the third to result in overall proportionate de-risking anyway. [1] In any case, the benefit to a second order derivative close-out right is that it might allow you to get ahead of the game. If I know the default is coming (because NAV trigger, right?) why wait until a payment is due to see if I get hosed?
Because, in this age of high-frequency trading, multiple payments are due every day, and even if one isn't, in many cases you can force one by raising initial margin]][2]. All told, an actual failure to pay is deterministic. There is no argument. A NAV trigger breach - not so much.
Especially since an official NAV is only “cut” once for every “liquidity period” - monthly or quarterly in most cases - and it is hard to see how a credit officer, however enthusiastic, could determine what the net asset value was at any other time. On the other hand, credit officers don’t usually monitor NAV triggers anyway, so what do they care?
All rather tiresome, and quite unnecessary if you have the right, as most prime brokers do, to jack up initial margin at your discretion[3].
Even though generally they’re not actively monitored, NAV triggers lead to the tedious cottage industry of waiving their breach. This is because while a prime broker’s credit risk department won’t have the inclination (or bandwidth) to monitoring the thousands of NAV triggers it has buried in its corpus of legal documentation, each hedge fund who has granted one will and, if[4] it suffers a significant drawdown, won’t like an unexploded Additional Termination Event sitting on its conscience.It will ask for a waiver. If it has clever lawyers, it will explain that it has heightened cross default risk as a result. It may insist on one, even though you would think it ought to be in no position to be insisting anything.
Thanks to the no oral modification clause in Section 9(b) — which extends to waivers — a NAV trigger waiver must be given in writing[5]. This then leads to an argument between legal and the credit department as to whose job it is to send out this waiver.
Legal: “You imposed the stupid NAV trigger, so you can damn well send out waivers for it.”
Credit: “Help! Help! It’s a legal agreement! I am not qualified to do this! I cannot opine!”
You’ll never guess where the JC’s sympathies lie.
Practical solution
Presuming you have reserved the right, as any sensible prime broker will, to increase your initial margin at any time, there is a way out of this, which ought to work perfectly well, but which your credit department will not like. That is to relegate the NAV triggers to any margin lockup you have agreed.
This means the NAV trigger is no longer, of itself, a Termination Event under the ISDA Master Agreement. All it entitles you to do is raise initial margin. Calling for more IM will achieve one of two things:
- The counterparty will deliver it, in which case your credit position, if precarious, can be sated;
- The counterparty can fail to deliver it, in which case you have a Failure to Pay or Deliver, being a much more robust Event of Default to take action.
Thus, it doesn’t trouble fastidious types who fuss about cross default or DUST, and the consequences of the trigger are in any case less apocalyptic for the fund, and less demanding of a waiver.
“But I don’t want to have a margin lockup just so I can have my NAV trigger”, your credit will wail. Sigh.
See also
References
- ↑ Not always precisely, of course: thanks to Mr. Woodford for reminding us all that a manager handling redemptions will tend to nix liquid positions first.
- ↑ Assuming you have undercooked your IM calculations in the first place, that is. IM is designed to tide you over between payment periods after all.
- ↑ I know, I know, there may be a margin lockup.
- ↑ When.
- ↑ This has been recently confirmed in Rock Advertising Limited v MWB Business Exchange Centres Limited.