|Prime Brokerage Anatomy™|
There is no industry standard prime brokerage agreement, so this is not so much an anatomy as a collection of resources about an amorphous subject.
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?
Types of NAV trigger
Often there are three levels of trigger: Monthly; Quarterly and Annually. There is also an “absolute” NAV trigger, judged from the inception of the relationship to the current point in time, though the sense this one presumably makes to the Worshipful Company of Credit Officers, has for many years eluded the JC. In any case you may find yourself in a tedious argument about whether your periodic NAV triggers should be “rolling” (that is, judged for the period from any day, even one on which there wasn’t an official NAV) or “point-to-point” (that is, judged between NAV calculation periods), which is more observable, being based on official NAV, but still arbitrary, as it gives you just a once-a-month opportunity to create a stink.
The exhilarating process of waiving a NAV trigger breach
Even though NAV triggers aren’t usually monitored, they can lead to the tedious cottage industry of waiving their breach. This is because while a prime broker’s credit department won’t have the inclination (or bandwidth) to monitor the thousands of NAV triggers it has buried in its contract portfolio, each hedge fund who has granted one will and, if it suffers a significant drawdown, won’t like an unexploded Additional Termination Event sitting on its conscience. So, 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.
No no-one likes to give a free waiver. Why would you?
Yet, thanks to the no oral modification clause in Section 9(b) — which extends to waivers — you must waive a NAV trigger in writing. This then leads to an argument between legal and credit as to whose job it is to send out this waiver. Honestly, this is such fun.
You’ll never guess where the JC’s sympathies lie. By the way, waiving a breach of contract under English law, without consideration, is unlikely to permanently change your contractual terms for the worse — a motivating fear of all legal eagles and credit officers — but may well do, if you are not careful, under the laws of the State of New York as it may create a course of dealing.
So, put the NAV trigger in a margin lockup
Presuming you have reserved the right, as any sensible prime broker will, to increase initial margin at any time, there is a way out of this. It ought to work perfectly well, though credit won’t like it: put NAV triggers in the margin lockup and not the master agreement.
(Why won’t credit like it? Because it means they won’t have anything to do.)
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.
- 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 under-cooked 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. That’s really the best place for the NAV trigger, as you may come to agree if you read on.
- Then again, you could make the point that cutting an official NAV once a month also gives one a somewhat arbitrary sense of the fund’s performance, as it does not track intra-month volatility.
- This has been recently confirmed in Rock Advertising Limited v MWB Business Exchange Centres Limited.
- See waiver by estoppel and no oral modification for a more developed discussion.
- See course of dealing.