Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Market risk represents the risk of financial loss from adverse movement in market prices. The primary sources of market risk are interest rates, foreign currency exchange rates, commodity prices, and equity prices.
Our business is exposed primarily to interest rate risk on variable rate interest bearing instruments, foreign exchange risk on non U.S. digital operating business and foreign denominated investments, the effect of market risk on our fee income and net carried interest allocation, equity price risk on marketable equity securities, and commodity price risk in connection with our digital operating business.
The following discussion excludes the effect of market risk on assets and corresponding liabilities that were held for disposition at September 30, 2022.
Interest Rate Risk
Instruments bearing variable interest rates include our debt obligations and loans receivable warehoused on the balance sheet for future sponsored investment vehicles, all of which are subject to interest rate fluctuations that will affect future cash flows, specifically interest expense and interest income, respectively.
Variable Rate Debt —Our corporate debt exposure to variable interest rates is limited to our VFN revolver, which was fully repaid as of September 30, 2022. In terms of investment level financing which totals $4.8 billion, this consists primarily of fixed rate securitized notes issued by our digital operating subsidiaries, Vantage SDC and DataBank, and fixed rate term debt financing TowerCo. Of this amount, $1.09 billion or 23% is composed of variable rate debt at September 30, 2022. Our variable rate debt is indexed largely to either 1-month or 3-month LIBOR, or 6-month Euribor. At September 30, 2022, our exposure to interest rate on the TowerCo variable rate debt is economically hedged with interest rate swaps. As our digital operating subsidiaries are substantially owned by third party investors, the resulting increase in interest expense from higher interest rates will be attributed predominantly to noncontrolling interests, with a minimal share of that effect attributed to DBRG. Based upon the outstanding principal on our variable rate debt at September 30, 2022, a hypothetical 100 basis point increase in interest rates would increase annualized interest expense, net of the effect of interest rate hedges, by $8.8 million on a consolidated basis or $1.2 million after attribution to noncontrolling interests.
Variable Rate Loans Receivable —We hold one warehoused variable rate loan receivable of $38 million at September 30, 2022, for which the transfer to our newly launched digital credit fund is expected to be completed in the fourth quarter of 2022. The risk of a decrease in interest rates that would reduce our interest income from the loan is low given the current increasing interest rate environment and the temporary nature of our holding.
Foreign Currency Risk
As of September 30, 2022, we have limited direct foreign currency exposure from our foreign operations in the digital operating business and foreign currency denominated investments warehoused on the balance sheet for future sponsored vehicles. Changes in foreign currency rates can adversely affect earnings and the value of our foreign currency denominated investments, including investments in our foreign subsidiaries.
We have exposure to foreign currency risk from the operations of our foreign subsidiaries to the extent these subsidiaries do not transact in U.S. dollars. This applies to our foreign subsidiaries that operate six colocation data centers in the U.K. and France, and TowerCo assets in Belgium. For the substantial majority of our subsidiaries in Canada that operate our hyperscale data centers, the U.S dollar is used as the transactional currency, in which case, there is no foreign currency exposure. The remaining foreign subsidiaries in our colocation data center business that do not transact in U.S. dollars make up only a small percentage of our overall digital operating business, which in turn is substantially owned by third party investors. As it relates to our EUR denominated equity investment in TowerCo, we have entered into foreign exchange contracts as a net investment hedge. Accordingly, our exposure to foreign currency risk from the operations of our foreign subsidiaries is limited as of September 30, 2022.
Our foreign currency denominated investments, which are temporarily warehoused on the balance sheet, are held by our U.S. subsidiaries. We generally mitigate foreign currency risk on our foreign currency denominated investments by utilizing currency instruments as economic hedges, such as foreign currency put options, forward contracts and costless collars. The maturity dates of these instruments approximate the projected dates of related cash flows from the respective investments. At September 30, 2022 , our foreign currency exposure consisted of a GBP loan receivable (£35 million) and an AUD equity investment (A$35 million). As of September 30, 2022, we have entered into foreign exchange forward contracts to mitigate our GBP exposure.
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In connection with our commitment to acquire AMP Capital, our consideration payable in U.S. dollar equivalent is largely fixed based upon the foreign exchange rate as of the date of the purchase agreement. The consideration is payable in U.S. dollars at the spot foreign exchange rate on the closing date of the acquisition, provided that such rate is not A$0.02 higher or lower than the rate on the date of the purchase agreement.
Market Risk Effect on Fee Income and Net Carried Interest Allocation
Management Fees —To the extent management fees are based upon fair value of the underlying investments of our managed investment vehicles, an increase or decrease in fair value will directly affect our management fee income. Generally, our management fee income is calculated based upon investors' committed capital during the commitment period of the vehicle, and thereafter, contributed or invested capital during the investing and liquidating periods. To a lesser extent, management fees are based upon the net asset value of vehicles in our digital liquid securities strategy, measured at fair value. At September 30, 2022, our digital liquid securities strategy make up 4.9% of our $21 billion FEEUM. Accordingly, most of our management fee income will not be directly affected by changes in investment fair values.
Incentive Fees and Carried Interest —Incentive fees and carried interest, net of management allocations, are earned based upon the financial performance of a vehicle above a specified return threshold, which is largely driven by appreciation in value of underlying investments. Carried interest is subject to reversal until such time it is realized, which generally occurs upon disposition of all underlying investments of an investment vehicle, or in part with each disposition. The extent of the effect of fair value changes to the amount of incentive fees and carried interest earned will depend upon the cumulative performance of an investment vehicle relative to its return threshold, the performance measurement period used to calculate incentives and carried interest, and the stage of the vehicle's lifecycle. Investment fair values in turn could be affected by various factors, including but not limited to, the financial performance of the portfolio company, economic conditions, foreign exchange rates, comparable transactions in the market, and equity prices for publicly traded securities. Therefore, fair value changes are unpredictable and the effect on incentive fee and carried interest varies across different investment vehicles.
Equity Price Risk
At September 30, 2022, we had $150.0 million of long positions and $35.1 million of short positions in marketable equity securities, held predominantly by our consolidated sponsored liquid funds. Realized and unrealized gains and losses from marketable equity securities are recorded in other gain (loss) on the consolidated statement of operations. Market prices for publicly traded equity securities may fluctuate due to a myriad of factors, including but not limited to, financial performance of the investee, industry conditions, economic and political environment, trade volume, and general sentiments in the equity markets. Therefore the level of volatility and price fluctuations are unpredictable. Our funds constantly rebalance their investment portfolio to take advantage of market opportunities and to manage risk. Additionally, one of our funds employs a long/short equity strategy, taking long positions that serve as collateral for short positions, which in combination, reduces its market risk exposure. The effect of equity price decreases to earnings attributable to our shareholders is further reduced as our consolidated liquid funds are substantially owned by third party capital, which represent noncontrolling interests.
Commodity Price Risk
Certain operating costs in our data center portfolio are subject to price fluctuations caused by volatility of underlying commodity prices, primarily electricity used in our data center operations. We closely monitor the cost of electricity at all of our locations and may enter into power utility contracts to purchase electricity at fixed prices in certain locations in the U.S., with such contracts generally representing less than our forecasted usage. Our building of new data centers and expansion of existing data centers will also subject us to commodity price risk with respect to building materials such as steel and copper. Additionally, the lead time to procure data center equipment is substantial and procurement delays could increase construction cost and delay revenue generation.
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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.