Leverage for AIFMD purposes: response to IOSCO Consultation Paper

The BVCA has contributed to an industry response led by Invest Europe and the American Investment Council in relation to a consultation published by The International Organisation of Securities Commissions (IOSCO) on creating metrics to help regulators measure the systemic risk posed by leveraged investment funds. This response calls on IOSCO to acknowledge explicitly the particular circumstances of institutional closed-ended funds.

The IOSCO Report

In November 2018, IOSCO published a consultation paper requesting feedback on a proposed framework to help measure leverage used by investment funds which in certain circumstances could pose financial stability risks. The paper was published in response to a request made by the Financial Stability Board in a 2017 report for IOSCO "to identify and/or develop consistent measures of leverage in funds to facilitate more meaningful monitoring of leverage for financial stability purposes and help enable direct comparisons across funds and at a global level". The paper defined leverage as a financial technique generally used to increase investment exposure, allowing a fund to increase its potential gains, as well as losses, by using financial instruments and/or borrowed money to increase the fund's market exposure beyond its net asset value. The paper noted that rules relating to leverage in funds, and its measurement, vary across different jurisdictions. Given the potential risks leverage brings to both investors and financial markets, IOSCO set out a proposed framework intended to facilitate regulators calculating and analysing leverage in funds in a sufficiently consistent manner across jurisdictions. IOSCO proposed a two-step process.

• The first step consists of regulators excluding from consideration funds that are unlikely to pose risks to the financial system and therefore do not require further analysis.
• The second step focuses on risk-based analysis of the category of funds identified in the first step.

The paper then focuses on three possible metrics for measuring leverage within investment funds, as part of the first step of the two-step approach, considering their advantages and limitations.

Response from Invest Europe and the American Investment Council

The response from Invest Europe and the American Investment Council was published on 1 February 2019. It specifically calls for private equity funds (and similar closed-ended funds) without withdrawal rights to be excluded under the first step of the analysis. The rationale is that private equity funds are backed by uncalled committed capital from their investors. So any borrowing taken out by a private equity fund can often be quickly repaid by drawing uncalled capital from investors. Moreover, private equity funds often accept commitments from institutional investors who the manager believes are able to meet any capital calls made. This therefore poses no material risk to the financial system as the borrowing is backed by available capital from institutional investors The response further states that since undrawn commitments are not typically reflected in the net asset value of the fund, measures of leverage based on the ratio of borrowing to net asset value may give a misleading impression. The response proposes an adjusted net asset value measure, which would comprise the total of such commitments and the fund's net asset value. If this approach is not taken, The response recommends including uncalled capital commitments as a supplementary data point (in other words, a factor for regulators to take into account alongside the more formal metrics).

What next?

Fund managers should look out for IOSCO's final report and further developments in this area.