Leverage Breach After a NAV Fall in a Long-Short Fund
Meridian Capital runs an open-ended Category III AIF with NAV of ₹80 crore, down from ₹100 crore three months ago. The fund is long ₹60 crore of cash equities and has ₹140 crore notional of listed derivatives, of which ₹60 crore are short positions intended to hedge the cash book. The CIO wants to add a new ₹30 crore short derivative position, arguing that it will reduce net directional exposure. The risk officer computes gross exposure at ₹200 crore and says the fund is already above its leverage policy. The fund's leverage policy states that it will not exceed the regulatory ceiling of 2 times NAV. The CIO responds that hedged derivative positions should be netted before calculating leverage and that the new trade is therefore permissible. The matter reaches the investment committee two days before month-end, when the fund must report its leverage position to investors.
1. Calculate the fund's leverage position and assess whether the proposed new short derivative can be approved.
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Leverage calculation
NAV = ₹80 crore; 2x ceiling = ₹160 crore gross exposure. Current gross exposure = cash ₹60 crore + derivatives notional ₹140 crore = ₹200 crore = 2.5x. The fund is already in breach by ₹40 crore. The proposed ₹30 crore short raises gross notional to ₹230 crore = 2.875x, so on a gross basis it is clearly not permitted.
The CIO's netting argument: if the ₹60 crore shorts are effective hedges against the cash book, net directional exposure is ₹60 crore cash + ₹80 crore net derivatives = ₹140 crore, or 1.75x. Adding a ₹30 crore short could reduce net directional exposure further. But regulatory leverage is not simply directional net exposure; it is designed to capture gross exposure, and hedges can be recognised only under a documented, effective hedge policy. Moreover, the fund is already above its own policy. The new trade cannot be approved until the existing breach is cured.
2. How should the investment committee treat the short derivative positions that the CIO says are hedges?
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Hedge treatment
Hedges should not be rejected automatically, but they must be verifiable: same underlying, correlated tenor, documented hedge ratio, and tested for effectiveness. A short that merely tilts the book bearish is not a hedge. The risk officer should maintain a hedge register and compute both gross and net exposure. If the policy permits netting, the investment committee must still respect the 2x gross ceiling or a stricter internal limit. In this case, the existing ₹60 crore shorts may reduce net risk, but they do not erase the ₹200 crore gross figure. The proposed new short is a directional overlay, not a hedge of the cash book, because the cash book is already hedged. It should be treated as additional gross exposure.
3. Recommend the immediate actions the manager should take before month-end reporting.
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Immediate actions
- Reject the new trade.
- Reduce gross exposure to at most ₹160 crore within a defined cure period, preferably by cutting the least liquid or least justified derivatives.
- Notify the investment committee and compliance; assess whether the breach is reportable to SEBI and investors under the fund's policies.
- Disclose the breach and remediation in the month-end investor report, with gross and net exposure.
- Review the leverage policy to include a buffer, such as a 1.8x trigger, so NAV falls do not cause automatic breach.
- Do not use new subscriptions to cure leverage without disclosure; if the breach cannot be cured quickly, consider suspending new subscriptions and consulting on redemption handling.