In applying the CVRDN as a licensee, a Fund Manager is able to offer a new "unfunded" access point to its investment strategy for use by both existing and new investors. Under this model, the Fund Manager causes the issuance and placement of a CVRDN with select Qualified Institutional Buyers, creating a pool of capital. These CVRDN proceeds are placed into a reserve account in the name of the Fund and governed by a third party trustee where they will await the Fund Manager's subsequent delivery of specifically formatted letters of credit, known as Principal Letters of Credit, that, by their nature, are not intended to be drawn under a performing CVRDN transaction. The Principal Letters of Credit act to credit enhance the CVRDNs, triggering a note conversion feature that releases reserved proceeds expressly for application to the investor-approved investment strategy of the Fund.
Using this mechanism, a Fund can cost-effectively raise a pool of lower cost debt capital to be deployed to its investment strategy when Principal Letters of Credit are delivered by participating lenders or investors in the Fund. This structure serves to functionally disaggregate the capital access raised through the conventional capital markets from the credit support of the Fund's operation. This creates a potential arbitrage between the cost of capital associated with the CVRDN plus the cost of the associated credit enhancement provided by the Fund's investors and the performance of the Fund. That net differential breeds an opportunity for the Fund Manager to increase its percentage-based participation in the Fund's performance in consideration of giving the investors the opportunity to enjoy Fund exposure without a cash investment in the Fund while further benefiting the investor through a reduction in management fees charged by the Fund.
When applied prudently and consistently using a conservative return expectation related to the Fund, a standard "2 and 20" hedge fund model can potentially morph into a "0.50 and 50" model while still producing an outsized internal rate of return on cash (given the investor's low cash basis in the trade) and leaving an increase of performance-based margin for the Fund Manager. Under this type of scenario, in the event of a draw under any of the Principal Letters of Credit resultant from a Fund Manager default under the CVRDN terms, the worst case for the investor is that its "unfunded" exposure to the Fund is then "funded" and reverts to a standard "2 and 20" model. From this perspective, it is more readily seen that this type of cashless investment has the same investment risk profile as a parallel funded investment in the Fund, but for as long as the letters of credit remain undrawn and any cash investment correspondingly deferred, a Fund Manager is able to offer a unique opportunity for its investors to enjoy outsized returns when calculated against the actual cash invested.