Credit facilities increase the value of a fund’s assets beyond its Net Asset Value (“NAV”). The greater the delta between the two, the higher the fund’s risk profile. Funds offered in the EU must therefore disclose information on their use of leverage and, in certain cases, cap their leverage amount.

Leverage is the ratio of a fund’s exposure to its NAV. NAV is the fair value of assets minus liabilities. Borrowings are the most common form of leverage. The maximum leverage must be disclosed as a ratio (expressed as a percentage) of the maximum amount of assets over the fund’s NAV. A fund that plans on an exposure of 300 and NAV of 100 therefore has to disclose a maximum leverage of 300%.

When EU lawyers discuss borrowing or leverage limits with US counterparts, the US counterparts may understandably perceive the leverage percentage to be applied to the fund’s NAV to calculate the maximum debt level, instead of the maximum level of exposure. As such, the 300% figure would be wrongly understood as permitting maximum borrowings of 300, resulting in a maximum exposure of 400 and thus leverage, within the meaning of AIFMD, of 400%. A misunderstanding of the metric may therefore result in inaccurate disclosures, commercial misalignment and potentially a breach of leverage limits.

Misalignment may also arise when EU lawyers or fund service providers discuss with deal teams and administrative teams. Deal teams often rely on metrics, such as the debt-to-equity ratio and the loan-to-value ratio. A fund with a maximum leverage ratio of 300% has a maximum debt-to-equity ratio of 2:1, or 200%, and a maximum loan-to-value ratio of 2:3, or 67%. When discussing borrowing capacity of a fund it is therefore paramount to start from the same metric.

The relevant metrics are not only a recipe for transatlantic confusion but may create confusion within the EU. The EU retail product ELTIF and the Luxembourg Part II fund product must define their borrowing caps as a percentage of their NAV (50% or 100% depending on investor base), and for the Part II, if marketed to unsophisticated retail investors, as a percentage of their assets or commitments to subscribe (70%) respectively. When expressed as leverage caps, these translate respectively to 150%, 200% and 333%, the latter calculated by reference to assets.

Therefore, to avoid inaccurate disclosures, commercial misunderstandings and potential breaches of applicable regulatory borrowing or leverage limits, it is important to ensure that all parties are using the same metric and calculation methodology when discussing leverage and borrowing.

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