New contenders to prime brokerage
Organisations such as BlackRock are well-placed to provide prime brokerage to hedge fund managers that are being exited by bulge bracket banks.
A number of prime brokers including Credit Suisse, Deutsche Bank, Goldman Sachs and Bank of America Merrill Lynch have been terminating hedge fund relationships, particularly those managers deemed unlikely to grow Assets under Management (AuM) or which are unprofitable.
This comes as Basel III capital requirements pile pressure on prime brokerage. Liquidity capital ratio and net stable funding ratio requirements are going to have major ramifications on prime brokers’ relations with hedge fund managers.
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. As such, this opens the door to non-bank financial institutions to enter the fray.
There has been widespread debate as to which entities will fill the prime brokerage void. 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 speculated credit funds or large hedge fund managers could provide financing. However, groups such as BlackRock are growing their prime brokerage operations and could emerge as major challengers to banks.
The rising financing costs have resulted in a swing from the multi prime brokerage model that proliferated in the aftermath of the Lehman Brothers failure. TABB Group research in 2014 highlights that hedge funds and long-only managers are using fewer prime brokers since the financial crisis, and added this trend was likely to continue.
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.
A growing number of hedge funds are rejigging their businesses by expanding their treasury function, particularly those running large, leveraged multi-strategy funds. 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 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.