Hedge funds urged to start PB financing negotiations now
Hedge fund managers should start negotiations with their prime brokers and scale back on the number of counterparty relationships they have if they want to obtain favourable financing terms as primes look set to curb their financing operations once Basel III capital requirements take effect.
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.
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. Irrespective, the cost of financing is going to get higher for hedge funds.
“Hedge funds must open up a dialogue with their prime brokers now in order to understand how their books are being viewed by prime brokers in terms of funding. The repercussions of Basel III are forcing fund managers to become more aware of their balance sheet usage, and it will ultimately result in the hedge funds needing to think more like a funding counterpart to their prime broker. Addressing the financing challenges Basel III will bring about is essential,” said Sandy Kaul, head of business advisory services at Citi in New York.
Attaining preferable financing is likely to result in hedge funds scaling back on the number of prime brokerage relationships they have. “The trend following 2008 was for managers to appoint around six to eight prime brokers. We think hedge funds will scale back their prime broker relationships by about one third. I believe investors will recognise this is necessary, and as long as managers continue to multi-prime and be diversified, investors will remain satisfied,” explained Kaul.
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.
“Some strategies will feel the pinch sooner than others but I believe all strategies will ultimately be impacted over time. At present, fixed income relative value strategies are struggling to obtain leverage for repo, and this is likely to continue. The only strategy likely to be spared will be futures-based commodity trading advisors (CTAs) who trade all of their products on-exchange,” said Kaul.
There are alternative sources of funding other than that supplied by prime brokers, although these are not cheap. There have been hedge funds raising permanent capital via closed end funds or through 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.
“While reinsurance vehicles can provide an alternative source of funding, these are very expensive arrangements to set up and require enormous infrastructural investment, not to mention skilled and experience staff. It is not a viable option for smaller managers but will mainly be the preserve of the largest hedge funds,” said Kaul.