Fund Level Hedging Series – Deferred Premium Caps

Institutional investors are increasingly looking for ways to be more thoughtful about how they protect their downside. Rather than treating every cap as a one-off expense at the asset level, many groups are rethinking how they hedge. One of the most overlooked (but valuable) opportunities is leveraging a fund level entity, whether for the benefit of a single asset or the entire fund.

Since fund level hedging has become a common topic of discussion, we’re rolling out a primer over the coming weeks to look at some of the creative possibilities.  

Last week we broke down the concept of a deferred premium cap – the exact same protection as a vanilla cap, but paid over time. Now, we’ll take a look at how it fits in with a fund level hedging strategy.

How it works

One way to leverage a fund entity to trade caps is the premium deferral. There are two variations.

The 101 – defer a portfolio hedge

The easy version is just a traditional deferred premium cap executed at the fund level. The fund buys a cap as a general portfolio hedge and defers the premium via equal monthly payments over the life of the hedge. Nothing exotic, just applied to a portfolio instead of a single loan.

The 201 – bifurcate the cap and the deferral

The more complex version buys the cap under the asset level borrowing entity to satisfy a lender’s hedge requirement and simultaneously defers the premium at the fund level.

As seen below, the cap lives in one place, and the payment obligation lives in another.

How does a lender see it?

This still satisfies a hedge requirement. From the asset level perspective, nothing about the cap changes. Why?

• The cap is an asset of the borrowing entity, collaterally assigned to the lender, just like a cap paid upfront.
• Cap payouts go wherever they’re directed based on the collateral assignment – no different than usual.
• If the borrower defaults, the cap is the lender’s collateral and can be monetized with no competing claim against it.
• The deferral is a separate liability of the fund. It sits off to the side and doesn’t touch the cap or impact its value. From a lender’s perspective, deferring the premium at the fund level is really no different than drawing on a revolver to pay for the cap.

Put simply, from the lender’s view it feels like any other cap that was paid for upfront.

One thing to confirm first

Before you push go, read the loan docs and have a conversation. Some include language amounting to “the hedge shall be in the form of a cap, with the only liability being a one-time payment.”

We’re not attorneys, and depending on how this is interpreted, it could capture a deferral at the fund. While these strategies are possible, they tend to only be executed by large institutional players who have thoroughly vetted them and tied up any loose ends.

There’s a lot you can do once the fund is set up to trade, and we’ll keep walking through the possibilities of fund level hedging next week.

Interested in leveraging your fund or weighing other strategies for an upcoming financing? Give us a call at 704-887-9880, email us at pensfordteam@pensford.com, or respond directly.