Some funds will attempt to optimize their value for investors by financially engineering the fund's capital structure. The most common approach is to replace some of the fund's equity with cheaper bank debt. However, increasing a fund's leverage also increases its risks to equity. Therefore, while determining the level of leverage, the fund needs to strike a balance between risk and reward for the equity investors.
One of the significant risks with the leverage approach occurs when the debt term is shorter than the fund term. This introduces a refinancing risk to the fund that did not previously exist (the refinancing risk is the amount of debt or cost that differs from the original amounts). Undoubtedly, there are leveraged funds that, in the current financial market, will not be able to refinance the leverage debt on the same terms; these funds may face the possibility of equity calls to re-leverage.
Throughout this Report, references are made to the returns an investor might seek and the risk-return relationships. The following section summarizes how investors measure their returns and the decision-making process that underlies the decision of whether or not to invest.