§ 12.03 Total Return Swaps
| Jurisdiction | United States |
| Publication year | 2022 |
§ 12.03 Total Return Swaps
[1]—General
Total return swaps are an effective financial tool for private investment funds that want to obtain leverage on their investments in a variety of asset classes, including corporate loans, bonds or even other hedge funds ("reference assets"). Total return swaps enable investment funds to obtain the economic exposure to a reference asset or a portfolio of reference assets on a leveraged basis without taking ownership of the reference assets. The investment fund will receive all of the cash flow benefits of the reference assets without actually owning them. During the life of the transaction, the investment fund will receive from the swap dealer all cash flows received on the reference assets and in exchange, the investment fund will make periodic payments to the swap dealer equal to the financing cost of an investment in the reference assets. At the end of the transaction, or at pre-determined time periods, the investment fund will make a payment to the swap dealer in an amount equal to the decline of the reference assets or the swap dealer will make a payment to the investment fund in an amount equal to the increase in value of the reference assets. The investment fund may have the option, at the end of the transaction, to purchase the reference assets at the then prevailing market price. Typically, the swap dealer (or an affiliate of the dealer) will own the reference assets; however, the dealer is not required to own the reference assets.45
[2]—Leverage
The main reason investment funds enter into total return swaps is to obtain leverage. Investment funds make an initial cash payment (or more typically delivery of upfront collateral) to the swap dealer equal to a percentage of the market price of the reference asset. The difference between the value of the upfront collateral and the purchase price of the reference assets is the leverage. The periodic cash flows described above are typically made on a net basis. Accordingly, assuming that the financing cost (historically expressed as LIBOR46 plus a spread) is less than the return on the reference assets (such as interest payments payable on the reference assets or an increase in the value of the reference assets), the investment fund will receive a net payment from the swap dealer. Most swap dealers will require a daily mark-to-market on the reference assets. The investment fund will be required to deliver additional collateral if the market price of the reference assets decline.
[3]—Ancillary Benefits to Total Return Swaps
There are other reasons for investment funds to utilize total returns swaps, although they are typically ancillary to the main reason (leverage). Other reasons include the ability to outsource the administration and operation of trading and maintaining the reference assets and the ability to gain exposure to reference assets that an investment fund might not otherwise be able to own due to, for example, eligibility restrictions on ownership and issuer consent rights to any transfer. If the total return swap is characterized as a derivatives contract instead of a secured financing, there are additional benefits. Typically, the swap dealer will not incur a substantial regulatory charge if derivative accounting treatment is achieved. In addition, in the case of a bankruptcy of the investment fund, certain swap agreements are exempt from the automatic stay imposed by the Bankruptcy Code, and the swap dealer may be permitted to terminate and liquidate the transaction outside of the bankruptcy proceeding.47 These features will enable the swap dealer to provide the investment fund better financing terms.48
[4]—Total Return Swap Facilities
Many swap dealers are willing to offer investment funds committed facilities. Under a committed facility, the swap dealer agrees to "finance" an agreed-upon purchase of reference assets (synthetically) so long as the reference assets meet certain agreed-upon eligibility criteria. Such criteria are very similar to the investment restrictions to which a CLO may be subject.49 The particular asset criteria must be satisfied before such reference asset may be purchased. The portfolio of reference assets will also be subject to additional criteria at all times after purchase. Typical criteria for a loan portfolio include: (1) limitations on currencies of reference assets; (2) jurisdiction of borrower; (3) pricing sources to obtain bids; (4) minimum market price; (5) minimum size of credit facility; (6) specified rating of borrower (7) first lien or second lien; (8) maximum weighted average rating factor; and (9) industry concentration. The pricing terms (e.g., financing rate, upfront collateral, margin terms) are agreed upon between the parties at the time of entering into the total return swap. Such terms will include a commitment fee on the unused portion of the facility. In an uncommitted facility, the investment fund and the swap dealer will agree in advance on the legal documentation, but each time the investment fund wants to purchase a reference asset, the swap dealer must agree to do the trade and the pricing terms are individually negotiated.
[5]—Recourse vs. Limited Recourse
Some total return swap facilities are structured purely as asset-backed financing facilities. The swap dealer's recourse under the transaction is limited to the collateral posted by the investment fund. Other facilities are full recourse such that if any amount remains unpaid to the swap dealer upon termination of the transaction, after determination of the final price on the reference assets and application of the collateral, the swap dealer may proceed against the investment fund for the shortfall. If the size of the swap facility is large relative to the fund, the fund's offering documents may need to be updated to disclose the key terms and risk factors regarding the facility. Disclosure will be especially important if the facility is full recourse.
[6]—Market Value Triggers
Total return swap facilities typically contain provisions whereby if the market price of the reference asset declines, the investment fund will be required to post additional collateral to the swap dealer. One of the key points to negotiate is how the then current market price of the reference assets is determined for purposes of determining whether (and how much) additional collateral must be posted. For more liquid reference assets, pricing services are typically used. Alternatively, bids may be obtained from other dealers in the market. For reference assets whose prices are not readily available through pricing services or for which bids are difficult to obtain, the swap dealer often wants to make such pricing determinations in its sole discretion. The determination of the market price of the reference assets can lead to contentious negotiations. The investment fund may want the right to dispute the determination and to include a dispute-resolution mechanism.
Another feature regarding market value triggers that is heavily negotiated is...
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