The leverage cap is the obvious cost of running a loan-originating AIF open-ended, and the smallest part of it.
On illustrative figures, structuring a loan-originating fund as open-ended under AIFMD II costs about 1.8 points of annual return on NAV: 8.45 per cent against 10.25 per cent for the same loans in a closed-ended fund. Only 0.625 of a point, 35 per cent of the gap, comes from the 175 per cent leverage cap itself. The rest is the headroom an open-ended fund must keep below the cap and the cash it must hold to meet redemptions.
Worked in full in The AIFMD II Handbook by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Directive (EU) 2024/927, AIFMD II, sets two leverage caps for loan-originating AIFs, measured under the commitment method as exposure divided by net asset value: 175 per cent if the fund is open-ended and 300 per cent if it is closed-ended. It also requires loan-originating AIFs to be closed-ended unless the AIFM can show its competent authority that the fund's liquidity risk management is compatible with its investment strategy and redemption policy. A manager choosing between the two structures needs to know what the open-ended route costs investors in return. The cap is the obvious answer and the smallest part of it.
| Input | Open-ended | Closed-ended |
|---|---|---|
| Leverage cap (commitment method) | 175% | 300% |
| Leverage actually run | 150% | 200% |
| Cash held for redemptions, % of NAV | 10% | 0% |
| Loan yield | 10.0% | 10.0% |
| Expected credit loss a year | 1.0% | 1.0% |
| Cost of borrowing | 6.5% | 6.5% |
| Yield on cash | 3.5% | n/a |
| Management fee, % of NAV | 1.25% | 1.25% |
The open-ended fund runs at 150 per cent, 25 points under its cap, because a fund at the cap breaches it after a modest markdown, as shown in how much markdown breaches the 175 per cent cap. Its exposure is at most 150 per cent however the cash is treated. The closed-ended fund runs at 200 per cent, well inside 300 per cent, which is closer to what its lenders will offer than to what the directive allows.
Loans = leverage − cash. Borrowing = leverage − 100%.
Open-ended: loans 1.40, cash 0.10, borrowing 0.50. Closed-ended: loans 2.00, borrowing 1.00.
Return = loans × (loan yield − loss) + cash × cash yield − borrowing × cost of debt − fee
Open-ended: 12.60 + 0.35 − 3.25 − 1.25 = 8.45%.
Closed-ended: 18.00 − 6.50 − 1.25 = 10.25%.
Excel, with leverage in B1, cash in B2: =(B1-B2)*(10%-1%)+B2*3.5%-(B1-1)*6.5%-1.25%
Each 25 points of leverage is worth 0.25 × (9.0% − 6.5%) = 0.625 of a point. Each point of NAV held in cash instead of loans gives up 9.0% − 3.5% = 5.5%.
| Step | Return on NAV | Cost |
|---|---|---|
| Closed-ended at 200% | 10.25% | |
| Held to the open-ended cap, 175% | 9.625% | 0.625 |
| Headroom below the cap, 150% | 9.000% | 0.625 |
| Cash sleeve of 10% of NAV | 8.45% | 0.55 |
| Open-ended fund | 8.45% | 1.80 |
The statutory cap accounts for 35 per cent of the gap. The headroom costs as much again, and it is a choice forced by the cap rather than written in it: a fund that ran at 175 per cent would breach on the first markdown. The cash sleeve is not an AIFMD II leverage effect at all. An open-ended fund needs liquidity to pay redemptions, and must also select at least two liquidity management tools from the directive's Annex V list, whatever its leverage.
The closed-ended fund could in principle run at 300 per cent and earn 12.75 per cent on these assumptions, with 2.00 of borrowing per unit of NAV. Lenders to a direct lending book are usually more conservative than that, which is why, on figures like these, the lenders' terms bind the closed-ended fund before the 300 per cent cap does, while the 175 per cent cap binds the open-ended one.
| Scenario | Open-ended | Closed-ended | Gap |
|---|---|---|---|
| Cost of debt 5.5% | 8.95% | 11.25% | 2.30 |
| Cost of debt 6.5% (base) | 8.45% | 10.25% | 1.80 |
| Cost of debt 7.5% | 7.95% | 9.25% | 1.30 |
| Credit loss 3.0% | 5.65% | 6.25% | 0.60 |
| Credit loss 5.0% | 2.85% | 2.25% | −0.60 |
The gap is the price of leverage, so it shrinks as the spread between net loan yield and borrowing cost narrows. At a 5.0 per cent loss rate the net loan yield falls to 5.0 per cent, below the cost of debt, and the less levered open-ended fund does better by 0.60 of a point. The open-ended structure gives up return in the base case and loses less in a bad credit year.
Pricing the open-ended structure as "175 instead of 300". On these figures that comparison would suggest a cost of 3.125 points, the 125 points of leverage between the caps at 2.5 points of spread, when the realistic gap is 1.80, and only 0.625 of that is the cap. The two numbers that decide the case are the leverage the closed-ended fund can actually borrow and the size of the open-ended fund's liquidity sleeve. Before that, check that the fund is loan-originating at all, under the test in when a fund is a loan-originating AIF.
The liquidity side of the same trade-off, Fund IV's reverse stress level with its facility, is computed in the free workbook for this book.
Directive (EU) 2024/927 caps leverage of a loan-originating AIF at 175 per cent of NAV if open-ended and 300 per cent if closed-ended, under the commitment method. In practice the open-ended fund runs below its cap: in the illustration at 150 per cent, which with a 10 per cent cash sleeve leaves 1.40 of loans and 0.50 of borrowing per unit of NAV.
Yes, but closed-ended is the default. An open-ended structure is allowed where the AIFM can demonstrate to its competent authority that the liquidity risk management system is compatible with the investment strategy and redemption policy. On illustrative figures the choice costs 1.80 points of annual return on NAV, 8.45 against 10.25 per cent.
Only while the net loan yield exceeds the cost of debt. With a 5.0 per cent annual credit loss the net yield in the illustration falls to 5.0 per cent against 6.5 per cent borrowing, and the open-ended fund at 150 per cent earns 2.85 per cent against 2.25 for the closed-ended fund at 200 per cent.
This article is one calculation from The AIFMD II Handbook. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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