GAIM Ops: Alternative sources of hedge fund financing could emerge

Prime Brokerage
13 Oct, 2014

Alternative sources of hedge fund financing could emerge as prime brokers scale back their financing as banks seek to meet their Basel III capital requirements.

Papers published by both Citi and J.P. Morgan in 2014 highlighted attempts by prime brokers to reduce their dependency on short-term funding, hedge fund investor restrictions on re-hypothecation of collateral and Basel III capital requirements are all going to lead to an increase in the cost of financing. 

“I wonder whether some actors in the shadow banking industry might step in to meet the prime broker financing challenges. There are entities around the world with significant pots of capital that are not subject to Basel III capital requirements, and they are focused on their Return On Capital (ROC) rather than their return on some form of regulatory measure such as Liquidity Coverage Ration (LCR). I strongly suspect there are some private firms and investors exploring this,” said Peter Coates, chief executive officer at Omni Partners, speaking at the GAIM Ops Conference in Dublin.

Private equity firms could be one primary contender for this as many are sitting on a lot of unspent capital. Preqin, the London-based data provider, said private equity firms were sitting on approximately $1.07 trillion of dry powder at the end of 2013, an increase of $130 billion from 2012. 

Some hedge funds have been raising permanent capital via closed-end funds or by establishing reinsurance vehicles. Reinsurance vehicles, often domiciled in Bermuda, enable managers to build up a fixed capital base not subject to redemptions and which are exempt from US taxation as long as the reinsurance vehicle is not conducting business in the US. A handful of managers including Paulson & Co have established such ventures.

The tightening up of financing is going to force hedge fund managers to scale back on the number of counterparty relationships they have. “Whereas in the aftermath of the financial crisis, hedge fund managers sought to diversify their prime brokerage relations to mitigate counterparty risk, managers are now going to have to contract the number of prime brokers they work with, in order to make the relationships more meaningful for both sides. The cost of financing has increased due to Basel III and its balance sheet capital requirements, and so primes are going to be less willing to finance certain hedge funds as much as they previously did,” said Coates.

Prime brokers highlighted that providing financing was not without its challenges. “Prime brokerage is a huge investment and it takes years to implement a quality system with a focus on technology, systems and capital introduction. There are huge barriers to entry, and at this point in time, we are seeing limited alternative lending sources emerging," said David Clarkson, EMEA head of prime brokerage at J.P. Morgan.

Investors were advised not to treat a change in prime broker - because of the changing financing terms - as a red flag. “There is likely to be a number of managers changing their prime broker line-up over the coming year or so, and investors should not necessarily be overly alarmed at this, as it may be based entirely on economics and servicing which are for the benefit of investors,” commented Coates.

A study by Barclays Prime Finance said the tightening on financing would disproportionately impact illiquid or highly leveraged strategies. The study said the average hedge fund’s returns could decline by 10 to 20 basis points with fixed income arbitrage – one of the most leveraged strategies at 13 times its Net Asset Value (NAV) – being hurt the most, with returns diminishing by anywhere between 40 and 80 basis points. “Certain prime brokers are going to support certain strategies. Some strategies won’t be profitable for the primes going forward.” said Coates.

The challenges around financing coincide with regulatory clampdowns on re-hypothecation. There is a strong possibility the European Commission (EC) could clamp down on re-hypothecation practices at prime brokers. Some expect the EC to emulate the Securities and Exchange Commission’s (SEC) Rule 15c3-3 which prohibits prime brokers from re-hypothecating more than 140% of a client’s debit balance, although the EC could impose a lower threshold. 

The EC has already proposed Securities Financing Transaction regulation, which requires alternative investment fund managers (AIFMs) and UCITS managers to give consent to assets being re-hypothecated. The collateral giver must be supplied in writing details of the risks re-hypothecation entails by the collateral taker and this must be confirmed by written agreement; and the financial instruments received as collateral must be transferred to an account in the name of the receiving counterparty. 

hedge fundsfinancingGAIM OpsLCRBasel IIIPreqinreinsuranceJ.P. MorganOmni PartnersBarclaysSecurities financing transactionAIFMsUCITSrehypothecation