Template:NAV trigger capsule

A NAV trigger is 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).

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. 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. 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 of the fund was at any other time, not having knowledge of those positions held with other counterparties. On the other hand, credit officers don’t usually monitor NAV triggers anyway, so what do they care?