Fund Level Hedging: The Buy/Sell Swap
Most lenders that require a hedge can’t actually provide one. When borrowing floating from a debt fund, Agency, or other non-bank lender, if there’s a hedge, it’s almost always going to be a cap procured from a third party bank. What if you’d prefer a swap though?
This week, we continue with our series on fund level hedging by looking at what’s often called a buy/sell swap. By leveraging a fund level trade, institutional borrowers have access to the fixed rate protection they want on a loan where it otherwise might not be possible.
How it works
The trade is structured with three pieces that net to one outcome:
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Buy the cap at the asset level to satisfy the lender’s requirement
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Sell an identical cap back at the fund level
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Execute a swap at the fund level
The two caps mirror each other and cancel out. In other words, whether SOFR resets at 0% or 20%, one pays exactly what the other collects.
That leaves just the swap, and the borrower’s all in rate equals the swap rate plus the loan spread.
We’ve included a simple illustration of the structure below.
Why do this?
There are a variety of reasons why someone might execute this strategy. Some common ones are as follows.
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While caps are simple and effective, the upfront cost can be burdensome, especially with longer terms (3+ years) or tighter strikes (<4.50%). Selling back an offsetting cap at the fund level returns the majority of the upfront premium, largely eliminating the out-of-pocket cost.
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There’s the preference for a fixed rate, whether that be for certainty, to maintain a specific fix/float percentage, or to hedge longer terms more efficiently.
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Some LPs take a more holistic approach to hedging by targeting a specific fix/float percentage at the fund level. Selling back offsetting caps and doing swaps allows them to achieve their goals without regard for the underlying loan type, lender requirement, or partner preference.
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A fund level swap provides the flexibility to choose whatever term is desired, or as I often put it, “choose your open window.” A typical fixed rate option might come with a 5, 7, or 10 year term, subjecting the borrower to a meaningful prepay penalty in the event of a sale/refi before maturity. The fund level swap allows the borrower to align the hedge as closely as possible with the business plan to mitigate the prepay risk.
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Side note, in the event the debt is repaid before the hedge maturity, the payoff can technically still occur without regard for the swap MtM. Since the swap is a liability of the fund, it can remain outstanding through its original maturity.
Regardless of the reason, a fund level swap provides optionality when a cap might typically be the only option.
What’s the risk?
Since the two caps offset, on a net basis, all that’s left is the swap. Therefore, the classic disadvantages of a swap apply. These include breakage risk if the hedge needs to be unwound and rates are lower. There’s also the missed benefit of lower rates if SOFR decreases or averages below expectations over the duration of the hedge.
Unlike a deferred premium cap, the MtM risk of a swap is much higher.
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The max breakage on a $100mm 1 year 4.00% deferred premium cap is roughly $267k.
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The max breakage on a $100mm 1 year 4.00% swap is roughly $4mm.
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Each scenario assumes rates go to 0% the day after executing.
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Building on the above, the MtM risk potentially opens the door for a margin call. While banks might do fund level trades unsecured or with a fund guaranty, in some cases, they might still institute guardrails around the amount of collective MtM exposure permitted before requiring collateral. There’s no one size fits all solution as these arrangements are bespoke.
Swaps are just another option in our series about fund level hedging. Keep in mind, these concepts are not for everyone and might make the most sense for institutional portfolios or edge case scenarios. Our goal is to just share some of what’s possible, and we’ll keep walking through the possibilities 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.