Venator Capital Management Ltd. and Venator Alternative Income Fund
Headnote
National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- relief from paragraph 2.6(2)(c), subparagraph 2.6.1(1)(c)(v) and section 2.6.2 of NI 81-102 to permit alternative mutual funds (i) to borrow cash up to 100% of NAV to facilitate currency hedging strategy, and (ii) to collectively short sell and borrow cash up to 100% of NAV for use in strategies for non-hedging purposes -- funds must remain 100% collateralized against borrowing for currency hedging strategy -- relief subject to routine conditions for short selling and cash borrowing for non-hedging purposes.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.6(2), 2.6.1(1)(c)(v), 2.6.2 and 19.1.
August 27, 2020
IN THE MATTER OF THE SECURITIES LEGISLATION OF ONTARIO (the Jurisdiction) AND IN THE MATTER OF THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS IN MULTIPLE JURISDICTIONS AND IN THE MATTER OF VENATOR CAPITAL MANAGEMENT LTD. (the Filer) AND IN THE MATTER OF VENATOR ALTERNATIVE INCOME FUND (the Existing Fund)
DECISION
Background
The principal regulator in the Jurisdiction has received an application from the Filer on behalf of the Existing Fund and similarly structured mutual funds managed by the Filer and which are "alternative mutual funds", as that term is defined in National Instrument 81-102 Investment Funds (NI 81-102) (the Future Funds and, collectively with the Existing Fund, the Funds) for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation) that exempts a Fund:
1) from the following provisions (the Total Borrowing Limit) of NI 81-102 in order to permit the Fund to borrow up to 100% of the Fund's net asset value (NAV) under the Cash Currency Hedging Strategy (as defined below),
a) paragraph 2.6(2)(c) of NI 81-102, that provides that an alterative mutual fund may borrow cash or provide a security interest over any of its portfolio assets if the value of cash borrowed, when aggregated with the value of all outstanding borrowing by the fund, does not exceed 50% of the Fund's NAV; and
b) section 2.6.2 of NI 81-102, which prohibits an alternative mutual fund from borrowing cash or selling securities short if, immediately after entering into a cash borrowing or short selling transaction, the aggregate value of cash borrowed combined with the aggregate market value of the securities sold short by the fund would exceed 50% of the fund's NAV;
(the Cash Currency Hedging Strategy Relief);
2) from the following provisions of NI 81-102 (the Total Borrowing and Short Sales Limit), in order to permit the Fund to borrow cash or short sell securities under the Leverage Strategies (as defined below), provided that, immediately after entering into a cash borrowing or short selling transaction, the aggregate value of cash borrowed combined with the aggregate market value of the securities sold short by the Fund does not exceed 100% of the Fund's NAV:
a) paragraph 2.6(2)(c) of NI 81-102;
b) subparagraph 2.6.1(1)(c)(v) of NI 81-102 that restricts an alternative mutual fund from selling a security short if, at the time, the aggregate market value of the securities sold short by the fund exceeds 50% of the fund's NAV (the Short Selling Limit); and
c) section 2.6.2 of NI 81-102;
(the Leverage Strategies Relief and together with the Cash Currency Hedging Strategy Relief, the Exemption Sought).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(i) the Ontario Securities Commission is the principal regulator for this application; and
(ii) the Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the other provinces and territories of Canada (the Other Jurisdictions and together with the Jurisdiction, the Jurisdictions).
Interpretation
Terms defined in NI 81-102, National Instrument 14-101 Definitions, and MI 11-102 have the same meaning if used in this decision, unless otherwise defined.
Representations
This decision is based on the following facts represented by the Filer:
The Filer
1. The Filer is a corporation incorporated under the laws of the Province of Ontario with its head office located in Toronto, Ontario.
2. The Filer is the trustee, investment fund manager, promoter and portfolio manager of the Existing Fund and will be the trustee, investment fund manager, promoter and portfolio manager of the Future Funds.
3. The Filer is registered under securities legislation in Alberta, British Columbia, Manitoba, New Brunswick, Newfoundland and Labrador, Nova Scotia, Ontario, Prince Edward Island, Quebec and Saskatchewan as an adviser in the category of portfolio manager and as a dealer in the category of exempt market dealer. The Filer is registered under securities legislation in Newfoundland and Labrador, Ontario and Quebec as an investment fund manager.
4. The Filer is not in default of securities legislation in any of the Jurisdictions.
The Funds
5. Each of the Funds is, or will be, organized as a trust established under the laws of the Province of Ontario or one of the Other Jurisdictions.
6. The Existing Fund is an alternative mutual fund as defined in NI 81-102. Units of the Existing Fund are currently offered by simplified prospectus (Prospectus), annual information form (Annual Information Form) and Fund Facts dated January 23. 2020, as amended, pursuant to National Instrument 81-101 Mutual Fund Prospectus Disclosure (NI 81-101) filed in each of the Jurisdictions is a reporting issuer subject to NI 81-102.
7. The Existing Fund invests in an actively managed portfolio of primarily North American fixed income securities.
8. Each of the Future Funds will be an alternative mutual fund as defined in NI 81-102. Each Future Fund will offer securities pursuant to either a Prospectus, AIF or Fund Facts pursuant to NI 81-101, or a long form prospectus and ETF Facts pursuant to National Instrument 41-101 General Prospectus Requirements, in one or more of the Jurisdictions and will be a reporting issuer subject to NI 81-102.
9. The Existing Fund is not in default of securities legislation in any of the Jurisdictions.
Reasons for the Exemption Sought
10. The investment objectives to be utilized by each of the Funds will differ but, in each case, investment strategies that may be utilized by a Fund will include the use of
(a) the Cash Currency Hedging Strategy that requires the use of cash borrowing in excess of the Total Borrowing Limit;
(b) the Leverage Strategies entailing
(i) additional cash borrowing for investment purposes in excess of the Total Borrowing Limit (Cash Borrowing Strategy);
(ii) the use of market-neutral, offsetting, inverse or shorting strategies (Shorting Strategies) requiring the use of short selling in excess of the Short Selling Limit; and
(iii) the combined use of the cash borrowing and short sales in excess of the Total Borrowing and Short Sales Limit.
The Cash Currency Hedging Strategy
11. The Existing Fund purchases foreign equity and fixed income securities in U.S. dollars and other foreign currencies, but the units of the Existing Fund are denominated in Canadian dollars and the Existing Fund's functional currency is the Canadian dollar. Accordingly, the Filer has determined that it is in the best interests of the Existing Fund to hedge substantially all of the Existing Fund's exposure to the foreign currency back to the functional currency.
12. Currently, the foreign currency exposure of the Existing Fund (i.e. U.S. dollars) is hedged back to the Canadian dollar using currency swaps. The Filer submits that the Funds can also hedge their foreign currency exposure back to the Canadian dollar in the spot currency market, directly and more efficiently, using a short position in the foreign currency.
13. The Funds propose to borrow cash in the foreign currency pursuant to a margin facility provided by their custodian to acquire foreign equities or fixed income securities denominated in the foreign currency (the Margin Facility). Using U.S. securities as an example, this would result in a Fund having exposure to a long position in U.S. securities denominated in U.S. dollars and a short position in U.S. cash. These long and short positions in U.S. currency offset one another and are an efficient hedge (the Cash Currency Hedging Strategy).
14. A Fund will monitor its long foreign securities positions and its short foreign cash positions under its Cash Currency Hedging Strategy on a daily basis. If the Fund's short foreign cash position exceeds the daily mark-to-market value of the Fund's hedged long foreign securities positions under its Cash Currency Hedging Strategy, the Fund will as quickly as commercially reasonable, take all necessary steps to reduce the short cash position to an amount that does not exceed the value of the Fund's hedged long foreign securities positions under its Cash Currency Hedging Strategy, which may include reallocating the excess short cash position as cash borrowing under its Leverage Strategies.
15. The objective of the proposed Cash Currency Hedging Strategy is to provide a direct hedge and not to make a speculative currency investment.
16. While specified derivatives can be used to create similar investment exposure as a short currency position, the Filer submits that the use of derivatives is more complex and more expensive. Derivatives are limited in duration whereas maintaining a short currency position is not. As a result, there is a potential mismatch between the duration of the derivative as compared to the duration of the holding of the long security position that is being hedged. On each settlement of the derivative, the Fund realizes the gain or loss resulting from currency fluctuations even though the Fund continues to hold the long security position being hedged. Implementing derivatives necessitates incremental transactional steps, expense and administration for the Funds.
17. The proposed Cash Currency Hedging Strategy is also "dynamic", meaning that when a Fund buys or sells a security there would be an automatic offsetting currency transaction in real time (intra month). However, using specified derivatives, if a Fund buys or sells a security intra-month, the Fund will either be over or under-hedged until the derivative settles or it will incur additional transaction costs related to smaller derivative transactions mid-month in order to be properly hedged. It is the Filer's belief that the use of forwards at this point is approximately 50% more expensive than the proposed Cash Currency Hedging Strategy.
18. Because it is a direct hedge, dynamic and less expensive and less administratively burdensome than hedging with specified derivatives, the Filer believes that the Cash Currency Hedging Strategy is in the best interests of the Funds with respect to hedging against currency risk in the portfolio.
The Leverage Strategies
19. In addition to cash borrowing under the Cash Currency Hedging Strategy, the Filer believes that it is in the best interests of each Fund to be permitted to use the Cash Borrowing Strategy and Shorting Strategies (collectively, the Leverage Strategies)to meet its investment objectives and strategies.
20. Shorting Strategies are well-recognized for limiting market risk, balancing long and short positions within an investment portfolio with the objective of providing positive returns regardless of whether the broader market rises, falls or is flat. Shorting Strategies are designed to have less volatility than the broader market when measured over medium to long-term periods. Shorting Strategies also provide diversification to investors as returns are intended to be uncorrelated to the performance of the broader market-such strategies are designed to effectively remove any "beta" component from their returns and investment exposures.
21. As part of an investment strategy, short positions can serve as both a hedge against exposure to a long position, or a group of long positions, and also as a source of returns with an offsetting long position or positions. The Funds will generally seek to generate an attractive risk/return profile independent of the direction of the broad equity markets. As such, at the portfolio level, these strategies seek to hedge out the Fund's exposure to the direction of broad equity markets, and to generate positive performance from the difference, specifically, the spread between the performance of the portfolio's long and short positions.
22. The Funds require the flexibility to enter into physical short positions in order to implement Shorting Strategies, when doing so is, in the opinion of the Filer, in the best interests of the Funds.
23. In addition, while there may be certain situations in which using a synthetic short position may be preferable, physical shorts are typically less costly, because of the ability to execute trades with a larger number of counterparties, compared to a single counterparty for synthetic shorts. This can result in wider options for borrowing securities resulting in lower borrowing costs. Funds may also be exposed to less counterparty risk than with a synthetic short position (e.g. counterparty default, counterparty insolvency and premature termination of derivatives).
The Strategies Generally
24. An alternative mutual fund that is subject to NI 81-102 is permitted to take leveraged long and short positions using specified derivatives up to a maximum of 300% of its NAV as set out in subsection 2.9.1(5) of NI 81-102 (the Leverage Limit). As such, the Exemption Sought would not be required if the Funds utilized solely specified derivatives (such as over-the-counter total return swaps) to obtain short exposure to the underlying cash or securities. NI 81-102 contemplates that alternative mutual funds may utilize shorting strategies (using a combination of short sale transactions and specified derivatives) subject to the Total Borrowing Limit, Short Selling Limit, Total Borrowing and Short Sales Limit and the Leverage Limit. Accordingly, the Exemption Sought simply allows the Funds to do directly what they could otherwise do indirectly through the use of specified derivatives.
25. The investment strategies of each Fund will permit the Fund to borrow cash, enter into specified derivatives transactions or sell securities short, provided that immediately after entering into a cash borrowing, specified derivative or short selling transaction, the aggregate value of cash borrowed combined with the aggregate market value of securities sold short and aggregate notional amount of the Fund's specified derivatives positions (other than positions held for hedging purposes, as defined in NI 81-102) would not exceed the Leverage Limit. If the Leverage Limit is exceeded, the Fund shall, as quickly as is commercially reasonable, take all necessary steps to reduce the aggregate value of cash borrowed combined with the aggregate market value of securities sold short and the aggregate notional amount of the Fund's specified derivatives positions (other than positions held for hedging purposes) to be within the Leverage Limit.
26. Any cash borrowing or physical short position entered into by a Fund will be consistent with the investment objectives and strategies of the applicable Fund.
27. The investment strategies of each Fund permit, or will permit, it to
(a) enter into a foreign cash borrowing transaction under the Cash Currency Hedging Strategy, provided that the aggregate value of foreign cash borrowed by the Fund under the Cash Currency Hedging Strategy does not exceed 100% Fund's NAV (Cash Currency Hedging Strategy Limit); and
(b) enter into a cash borrowing or short selling transaction under its Leverage Strategies, provided that at the time the Fund enters into a cash borrowing transaction or sells a security short (i) the aggregate market value of securities of any one issuer (other than "government securities" as defined in NI 81-102) sold short by the Fund does not exceed 10% of the NAV of the Fund and (ii) the aggregate value of cash borrowed combined with the aggregate market value of all securities sold short by the Fund under its Leverage Strategies does not exceed 100% of the Fund's NAV (Leverage Strategies Limits and together with Cash Currency Hedging Strategy Limit, the Permitted Total Borrowing and Short Sales Limit).
If any of the Cash Currency Hedging Strategy Limit, Leverage Strategies Limits or Permitted Total Borrowing and Short Sales Limit is exceeded, the Fund shall, as quickly as is commercially reasonable, , take all necessary steps to reduce the aggregate value of cash borrowed combined with the aggregate market value of securities sold short to be within the applicable limit or limits.
28. The Funds require the flexibility to enter into physical short positions when doing so is, in the opinion of the Filer, in the best interests of the applicable Fund and to not be obligated to utilize an equivalent short position synthetically through the use of specified derivatives as a result of regulatory restrictions in NI 81-102
29. The Filer, as a registrant and a fiduciary, is in the best position to determine whether the Funds should enter into a physical short position versus achieving the same result through the use of specified derivatives, depending on the surrounding circumstances. Accordingly, the Exemption Sought would permit the Filer to engage in the most effective portfolio management available for the benefit of the Funds and their unitholders.
30. In addition, while there may be certain situations in which using a synthetic short position may be preferable, physical shorts are typically less costly, because of the ability to execute trades with a larger number of counterparties, compared to a single counterparty for synthetic shorts. This can result in wider options for borrowing securities resulting in lower borrowing costs. Alternative mutual funds may also be exposed to less counterparty risk than with a synthetic short position (e.g. counterparty default, counterparty insolvency and premature termination of derivatives).
31. The Prospectus, AIF and fund facts will comply with the requirements of NI 81-101 and Form 41-101F4 Information Required in an ETF Facts Document applicable to alternative mutual funds, including cover page text box disclosure in the fund facts to highlight how the Fund differs from other mutual funds and emphasize that Leverage strategies permitted by the Fund are outside the scope of NI 81-102 applicable to both mutual funds and alternative mutual funds.
32. The investment strategies of each Fund will clearly disclose the Leverage Strategies of the Fund that are outside the scope of NI 81-102, including that the aggregate amount of cash borrowed and the market value of all securities sold short by the Fund may exceed 50% of the NAV of the Fund. The Prospectus will also contain appropriate risk disclosure, alerting investors of any material risks associated with such investment strategies.
33. The Filer has comprehensive risk management policies and/or procedures that address the risks associated with short selling in connection with the implementation of the investment strategy of each Fund.
34. Each Fund will implement the following controls when conducting a short sale:
(a) the Fund will assume the obligation to return to the borrowing agent the securities borrowed to effect the short sale;
(b) the Fund will receive cash for the securities sold short within normal trading settlement periods for the market in which the short sale is effected;
(c) the Filer will monitor the short positions within the constraints of the Exemption Sought as least as frequently as daily;
(d) the security interest provided by the Fund over any of its assets that is required to enable the Fund to effect a short sale transaction is made in accordance with industry practice for that type of transaction and relates only to obligations arising under such short sale transactions;
(e) the Filer will maintain appropriate internal controls regarding short sales, including written policies and procedures for the conduct of short sales, risk management controls and proper books and records; and
(f) the Filer will keep proper books and records of short sales and all assets of a Fund deposited with borrowing agents as security.
35. The Filer believes that it is in the best interests of each of the Funds to be permitted to borrow cash or engage in physical short selling in support of the Cash Currency Hedging Strategy and the Leverage Strategy, in excess of the current limits set out in NI 81-102 applicable to alternative mutual funds.
Decision
The decision of the principal regulator under the Legislation is that the Exemption Sought is granted provided that:
1. Under the Cash Currency Hedging Strategy:
(a) a Fund may only borrow foreign cash if immediately after the foreign cash borrowing transaction, the Fund's aggregate exposure to foreign cash borrowing under the Cash Currency Hedging Strategy does not exceed 100% of the Fund's NAV; and
(b) if the Fund's short cash position exceeds the daily mark-to-market value of the Fund's hedged long positions under its Cash Currency Hedging Strategy, the Fund will as quickly as commercially reasonable, take all necessary steps to reduce the short foreign cash position to an amount that does not exceed the value of the Fund's hedged long foreign securities positions under its Cash Currency Hedging Strategy, which may include reallocating the excess short foreign cash position as cash borrowing under its Leverage Strategies.
2. Under the Leverage Strategies, a Fund may sell a security short or borrow cash only if, immediately after the cash borrowing or short selling transaction:
(a) the aggregate market value of all securities sold short by the Fund under the Leverage Strategies does not exceed 100% of the Fund's NAV;
(b) the aggregate value of cash borrowing by the Fund under the Leverage Strategies does not exceed 100% of the Fund's NAV; and
(c) the aggregate market value of securities sold short by the Fund combined with the aggregate value of cash borrowing by the Fund under the Leverage Strategies does not exceed 100% of the Fund's NAV.
3. The Fund's aggregate exposure to short selling, cash borrowing and specified derivatives does not exceed the Leverage Limit.
4. In the case of cash borrowing, the cash borrowing arrangement:
(a) otherwise complies with all of the cash borrowing requirements applicable to alternative mutual funds under section 2.6 and 2.6.2 of NI 81-102; and
(b) is consistent with the Fund's investment objectives and strategies.
5. In the case of a short sale, the short sale:
(a) otherwise complies with all of the short sale requirements applicable to alternative mutual funds under section 2.6.1 and 2.6.2 of NI 81-102; and
(b) is consistent with the Fund's investment objectives and strategies.
6. The Prospectus under which units of a Fund are offered:
(a) discloses that the Fund can:
(i) under the Cash Currency Hedging Strategy, borrow foreign cash with a value up to 100% of the Fund's NAV;
(i) under the Leverage Strategies, borrow cash and short sell securities provided that the aggregate market value of securities sold short by the Fund combined with the aggregate value of cash borrowing by the Fund under the Leverage Strategies does not exceed 100% of the Fund's NAV; and
(b) describes the material terms of this decision.
"Darren McKall"
Manager, Investment Funds and Structured Products Branch
Ontario Securities Commission