40 3
The prospectus
Leverage and investment restrictions
Leverage restrictions may hold less value than their title suggests when
it comes to offshore funds. Sometimes they are silent on the subject;
more often they include very loose restrictions designed to leave the
manager a lot of flexibility should leverage be used. Professional inves-
tors have said to me that this is normal and quite acceptable, but in
my view this is not right. It is not because we trust managers that
we have to give them carte blanche. I think all prospectuses should
have a limit on leverage. If the manager wants to increase leverage
then it should inform investors and notify them if leverage limits
are breached. That would at least give investors the right to decide to
redeem if they prefer. If it is not in the prospectus an investor simply
has no right to know.
Most prospectuses include some form of investment restrictions that
investors may seek to rely on. These can be based on the standard
investment restrictions required, as I said, in the relevant jurisdiction
(if any) where the fund is set up or depending on its targeted base
of investors. For instance, generally retail funds must include by law
more restrictions such as limited exposure to any one stock to con-
trol concentration risks. Other restrictions that are sometimes seen are
based on those required for a listing: often in Europe this applies in
Ireland. All restrictions are good, although I have known of funds that
simply chose to ignore them. It is rare but if it happens in an offshore
jurisdiction with a dishonest manager it is hard for investors to do
much about it without incurring huge costs.
Confessions of a prospectus writer
There are a number of examples in the industry where the prospectus
includes clauses that directly prejudice investors. I want to illustrate
them so that investors can easily pick up on aspects of prospectuses
they should resist. These examples are related to offshore unregulated
funds which are the funds investors are most likely to struggle with.
They are also often the funds that make the press for related reasons.
case study
Leverage and investment restrictions 41
Although I did not write any of the prospectuses that contain the
examples below, I can understand what those who did were trying
to achieve. Let me tell you therefore about the consequences for
investors in each case.
Example 1
Here is an example of language that could be included in a prospectus
with regards to leverage:
Snapshot of the prospectus…
Leverage from derivatives
The share of the stock exchange margins on the total fund volume
shall not exceed 35 per cent. This could lead to a one-sided use of
the margin limit at a maximum leverage effect out of derivatives of up
to 12 times the actual fund volume (i.e. 1,200 per cent).
Total leverage of the fund
The expected leverage of investments in higher risk markets (such
as raw material, precious metal, energy) of the fund’s total leverage
is 5-8 times the actual fund volume. The maximum possible leverage
of an exemplary investment (long only) in risky markets may be up
to 15 times the fund volume, i.e. the basic equivalent volume of the
invested options and futures would be up to 15 times higher than the
actual fund volume.
Leverage is a very important topic and the cause of much of the
financial pain felt in 2008. Interestingly in 1998 leverage was also a
primary concern when the famous Long Term Capital Management
(LTCM) fund collapsed bringing to the brink many large financial
institutions (see Chapter 7 for the full story of LTCM). Yet, as you can
read below, not much has changed over a decade in the way leverage
is referred to in many prospectuses, leaving far too much freedom
to managers. Leverage is still, even as I write in 2012, rarely limited
in prospectuses or if it is, it is at levels that do not protect investors
enough, unless of course you are in a regulated European fund.
In effect in the language used here, the fund is pretty free to leverage
under two clauses to quite scary levels! The reality is that the fund
probably does not use this level of leverage. Nevertheless, investors
should wonder why such broad and relatively unlimited clauses are
included in prospectuses in the first place. The fact remains that if

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