Over the course of the last decade, bank lending to hedge funds and hedge fund-linked products has increased markedly and steadily. A wide range of credit providers now compete to gain exposure to the asset class through a diverse offering of products and financing techniques. Ten years after Man Investments entered into its first significant external leverage transactions, Alistair Bool, Laurence Fitzpatrick & Andy Knox of Man Investments’ Structuring Unit took a product provider’s look at the development of the market and commercial terms, bank approaches to lending risk and legal and operational considerations

The topic of hedge fund leverage potentially covers a vast range of activities from prime broker lending at the trading level to the kind of capital markets EMTN issuance recently undertaken by Citadel. It is important to distinguish between lending at product level into fund of hedge fund (FOHF) /structured products and leverage at a direct trading strategy level, for example by prime brokers and/or inherent in a particular trading strategy (eg. trading on margin as part of a futures-based CTA strategy). Very different considerations and characteristics apply to each and the former (leverage at FOHF/structured products level) is the main focus of this article.

At the product level itself, financing is used for a number of different purposes, primarily to increase available trading/allocatable capital or to provide liquidity facilities (at generally less than 25% loan to value). The remainder of this article concentrates on the former – essentially how diversified hedge fund portfolios are leveraged.
The market and commercial terms

The market for lending to hedge funds has changed dramatically in the last five years, with a significant increase in the number of participants active in the space. This growth has more than kept pace with the industry’s demands and can be attributed to a number of factors, including:-

• periodic reduction in traditional investment banking opportunities resulting in an increase in capital being deployed to the hedge fund lending business in search of returns;
• banks wanting to leverage off their increased industry knowledge gained through associated businesses such as their own FOHF offerings, prime brokerage, futures clearing, custodian, note issuance and the provision of capital guarantees;
• hedge fund providers wanting to deal with fewer, more strategic providers at all levels which has resulted in some institutions entering the lending business to protect their other existing businesses

Institutions that entered into this area quickly realised that lending to diversified FOHF portfolios was profitable and a lot less risky than many had initially thought. Additionally, as the industry has matured, the level of data available has increased markedly to the point that lenders can now point to favourable annualised volatility comparables – for example, for the period 31 December 1997 to 31 December 2006, annualised volatility for the HFRI Fund of Fund index was 5.9% as against 15.2% for the S&P 500 and 13.9% for the FTSE 100. This has meant that very few providers have exited the space and usually only as the result of teams with a high level of expertise being enticed to move on as others search for an entry route. However, as the competition has increased, those institutions that were late to the party have found it increasingly difficult to gain market share. Predictably, this has led to very aggressive terms being offered by inexperienced teams, so the currently low exit rate may well change.

While the ratings process with respect to hedge funds is not as standardised as the CDO market, it has allowed lenders outside of the investment banking market to gain exposure to the industry through debt which has a public or private rating thus further increasing capital available for leverage purposes. As one would expect, this explosive growth has transformed the leverage economics. In 2001, finance was supply-constrained, now demand is the main limitation and spreads have dropped as a result. In the last five years, spreads for four times leverage on a diversified portfolio have probably fallen by a third and while some downward pressure remains, most providers are looking to their lenders to assist them in other ways. These would include accepting less rigid investment guidelines, removing operationally intense structures, reducing reporting requirements or the provision of less profitable liquidity facilities alongside the more profitable leverage ones.

Whilst leverage providers focus on financing spreads, they also generally require some sort of guaranteed income to justify the due diligence and legal costs associated with setting up a facility. This may include underwriting legal and due diligence expenses, an upfront structuring fee or a commitment fee on unutilised amounts. One more recent development is the concept of minimum utilisation whereby the traditional commitment/structuring fees are replaced by the borrower committing to utilise the facility on average to a certain level over an agreed period. This allows the leverage provider to generate a minimum income level greater than would be the case with traditional fee structures and, provided that the minimum level is attained, the FOHF provider benefits from the fact that the banks’ commitment above this level is essentially ‘free.’ There is some downside risk in a long dated facility using this fee structure, if the utilisation rate drops off in later years to such an extent that a make-whole payment is due which would have to be borne by the remaining investors. However, provided that the utilisation levels are conservative and any potential make whole fee is accrued for appropriately, this risk should be controllable.

As the supply of leverage to the industry increases, many hedge product providers are locking some of this financing in place for a number of years to ensure the security of that leverage. In the early stages, banks were generally only comfortable with annual deals but, as has been the case with higher spreads, this position has been eroded by increased competition.

Secure financing is key to leveraged businesses and many providers are prepared to give up the chance to exploit further reductions in spreads for the security of committed financing in the medium to long term. To a degree, larger FOHF providers are able to hedge their bets by maintaining a diversity of tenor across their portfolio.

Securing longer term financing is not without its challenges. With respect to leveraging large institutional mandates, it is obviously risky (assuming some termination/break fee will be incurred) to arrange financing with a duration longer than the investor’s commitment/liquidity terms. In the private client sector, where products can have a large number of geographically diverse investors, historic redemption rates on similar products can be used as a guide to likely future redemption rates which allows the maturity of the financing to be extended with more confidence.

Agreeing investment guidelines that will be workable for the duration of the deal is also an important issue with long-dated financing and conflicts with the search for alpha which is continually pushing hedge funds into new territories, such as weather derivatives, making the future very difficult to predict. As a result, the FOHF provider will almost always be forced to renegotiate the investment guidelines at some point and reference to the investment guidelines being renegotiated in good faith after an agreed period provides little comfort for the FOHF provider. This risk may be mitigated by careful selection of leverage providers, focusing on those which are likely to be around to renegotiate when theneed arises and with whom the leverage provider has a relationship beyond individual financings. Another mitigating tool is to have the investment guidelines based on manager diversification and volatility rather than style and strategy limits which are much more likely to become outdated.

Reducing spreads, the willingness of banks to commit to longer maturities and the risk that investment guidelines will become unworkable are some of the main reasons why the public rated CFO market has not taken off as expected.

One important issue for a large product provider is the number of leverage providers it should have. There is no right answer, but there are some key areas that should be considered:

• A FOHF provider should always look to maintain relationships with enough providers to ensure competition exists on spreads, that the partners selected have capacity to allow the business to grow and to provide for sufficient diversification to avoid over reliance on any one entity. The development of the CP conduit vehicles, with their low funding costs and high lending appetite, has allowed many lenders to develop a lending book of a size which would have been unimaginable a few years ago.

The development of insurance wrap providers and the move into the sector by re-insurers has also increased the capacity of the traditional leverage providers who are able to offload risk at very competitive rates. Together with the development of the ratings process around hedge funds, this has resulted in the more mature players in the market increasingly playing more the role of lead arranger/risk monitoring agent and perhaps the provider of a CDS.

• Managers should avoid having too many providers where the operational risk and due diligence pressures can be excessive and act as a distraction for key staff.
• Avoid being a small customer with numerous providers. Instead, aim to be a significant customer with as many providers as possible with a view to opening doors/facilitating negotiation and implementation, whilst understanding the point at which additional mandates will have little impact (applying the basics of the law of diminishing returns).

Balancing these concepts can produce a target number of providers but the selection of those providers, based on qualitative assessments is vital. The key here is to focus on the experience and continuity of the team that you will be dealing with, their support by and access to senior management and of course the quality of the provider in the broader sense. Choosing providers on the basis of undemanding due diligence or pricing is a short sighted approach and anyone doing so is well advised to at least have a contingency plan in place should these providers and/or facilities be terminated at short notice

Risk – Investment guidelines

The top-down methodology of capping allocations to defined styles and strategies which is adopted by most finance providers and rating agencies is often a good fit for institutional-style FOHF providers which primarily seek a target level of diversity of style and strategy with the selection of managers within those styles/strategies a secondary issue.

However, the same approach can create conflicts when applied to FOHF providers who seek alpha from selecting specific underlying managers, given that the desire to invest in a specific manager may conflict with the consequences that such investment has on the standard tests. Whilst banks may accept the rationale of the bottom-up approach, the standard risk analysis essentially ignores manager identity. More specifically, although no two banks adopt the same investment guidelines, they generally focus (with variable weighting) on the same themes: liquidity, volatility and diversity.

Liquidity

For the product provider, delivering a sufficiently liquid portfolio presents a conflict between the needs of the finance provider and the availability of liquid investments. As alphais increasingly generated by managers either investing in less liquid markets (distressed for example) or with the desire and negotiating power to obtain committed investments, lock-ups are becoming more prevalent.

It is therefore increasingly difficult to ensure liquidity without compromising on style and manager selection. Furthermore, the needs of the investor may also muddy the waters: delivering permanent leverage on a portfolio with a high arbitrage or activist allocation may either be impossible or expensive.

Volatility

Some banks still use the liquidity/volatility matrix pioneered by ZCM to calculate the base haircut but a simpler approach is becoming more prevalent, either using a basket volatility cap (perhaps with de-leveraging buffers thereafter) or an underlying fund volatility cap (with a haircut on the proportion in excess of the cap).

Diversity

A diverse portfolio is easier to identify than it is to define and herein lies the greatest variation between the banks:

• Style: different portfolio managers use different definitions of hedge fund styles (global macro for one equates to directional for another). The lack of a consistent style definition reflects the wider market and provokes an ongoing debate with risk analysts as to which definitions should be applied.
• Strategy: the style debate is magnified at the strategy level. Fund providers may be grouped by trading style (market neutral, stat arb etc) or by trading sector (healthcare, commodities, emerging market etc). Naturally, the banks have their own approach and combining the two can be a lengthy process if the bank insists on strategy limits (not all do). Indeed, there is an interesting risk debate as to the value of strategy limits: whilst one can see the desire to limit exposure to volatile strategies (emerging markets being the classic example), there is less obvious benefit to horse-trading minor amendments to the proportion which can be allocated to primary hedging strategies: the implication being that an interest in changing a fixed income allocation from 20% to 15% betrays a lack of confidence in the hedged nature of the strategy. The picture is further clouded by the growth of ‘multi-strategy’ managers trading within a particular style: the non-specific nature of this strategy may limit the allocation that banks are prepared to permit. For this reason, the emphasis on liquidity, volatility and manager limits with a generous style diversity overlay appears a more logical approach.
• Manager: this is a consistent market theme and the only issue for the product provider is ensuring that the limits are appropriate for the specific product. Concentrated portfolios can obtain leverage but there may be a trade-off on liquidity, advance rates or pricing. As the FOHF provider wants to ensure it maintains control over its portfolios it will generally not allow the leverage provider to have any say in manager selection. The leverage provider therefore must focus on careful selection and due diligence on the FOHF provider that it chooses to do business with as it must rely on that provider in terms of manager selection.

Additionally, banks do not differentiate between managers within the same strategy categorisation even though correlation statistics may suggest this is not the correct approach. However, unless the FOHF provider involves the bank in the portfolio building process and gives it the opportunity to analyse the portfolio based on specific managers, which would have to be repeated following any change to the portfolio, it is difficult to see how this can be achieved.

Miscellaneous

As risk analysts become more accustomed to the asset class, there appears to be an increasing appetite for demonstrating either that the standard risk measures, or the formulae for their application, are insufficient. Accordingly some banks devote great resources to developing additional tests, for example, relating toAUM movements or underlying leverage. These can be frustrating for the product provider to the extent that they relate to information which is hard to obtain and appears to add little value. Novel formulae can also be (a) painful to explain to the FOHF portfolio manager and (b) difficult to analyse if they fall outside the usual risk parameters and, in each case, this complicates the process of obtaining guideline approval.

Correlation

Some risk analysts do not give specific credit for the lack of correlation between investment styles despite detailed research demonstrating that characteristic. This may be surprising as this correlation analysis is a basic portfolio manager risk tool.
Over-collateralisation

If advance rates and pricing are calculated on the assumption that the portfolio is compliant with the proposed limits but at the extreme in terms of concentration and volatility levels, one could expect to receive credit for more conservative compliance (ie. the portfolio being more diverse, less volatile etc than it needs to be).

This is a theoretical methodology which may not have been implemented because of the additional work that it would involve (ongoing stepped advance rate and pricing adjustments), but it may be something to consider on more unpredictable portfolios.

The implementation of investment guideline breaches varies. The optimal approach from the product provider’s perspective is to avoid any ‘hard’ limits, breach of which results in termination and instead to use ‘soft’ limits which result in haircuts and therefore an advance rate reduction. With bespoke products this may not be an issue, but for products with several lenders, it is crucial – the alternative is that the FOHF manager has to satisfy several different and potentially conflicting masters.

Whilst some banks maintain the ZCM base-haircut calculator approach for determining the initial advance rate, most simply fix an upper advance rate limit and then apply haircuts to reduce the collateral value where there is a breach. The main complexity that both product providers and banks face is applying a fair methodology where there is potentially more than one breach (for example, the biggest manager causes a breach of the style and strategy limits).

The traditional sequential haircut approach can be painful to document and irrational in application (different sequences can produce different haircuts). The alternative is to use an iterative algorithm which calculates the lowest haircut given all the limits and inputs: fine in principle, but complicated in practice.

While banks may make an operational distinction between investment guidelines and trigger events, for the product provider the latter require significant attention to the extent that they may generate surprise haircuts and excessive reporting obligations. The tension here is between the bank’s desire to exit or delever and the product provider’s need for secure financing over a longer period. As the market has become more competitive, this balance has swung in the product provider’s favour and has caused some transactions to be renegotiated. The primary concern for the product provider is to ensure that a deal cannot be terminated because of the malfeasance of one underlying manager or because the bank is desperate to exit. Assuming that allocations are made to third parties, it is vital that events outside of the product provider’s control do not result in a penalty for his investors. Applying haircuts to the portfolio is acceptable as it minimises the contaminating effect of one bad apple. In addition, there are a number of other potential triggers which are commonly negotiated, including:

• Discretionary language: banks like to cover their failure to identify specific risk concerns by a general catch-all provision eliminating any manager about which they have a ‘material concern’ – obviously this is hard to contest and could be used inappropriately. The samesort of effect may be found in provisions relating to changes to liquidity, volatility or AUM and should also be avoided.

This language may also be extended to cover reputational concerns. While banks may have a legitimate desire to avoid association with particular strategies (market timing being the classic example), they may use this as grounds to exit the leverage business simply because management decide that they no longer want to lend to hedge funds. Leverage would not be committed if the bank could terminate because hedge funds are receiving bad press: accordingly something for product providers to watch out for.

• Service provider events: a manager may be eliminated because of some event affecting his prime broker, administrator etc. Not only is this unfair but it greatly extends the reporting obligations of the product provider.

• Affiliate events: where the product provider is part of a larger investment business, it is very important to segregate the businesses to avoid the possibility that, for example, a regulatory enquiry into another unit in an unrelated jurisdiction could be used as grounds for termination.

• Manager events: the occurrence of a manager blow-up event should not be grounds for termination as it is a foreseeable risk of lending to hedge funds for which the banks are being compensated.

Structuring: legal & operational issues

As the industry has developed, the sophistication of structuring teams (and their lawyers) has kept pace. In this section, we take a brief look at some of the primary structures used by the banks and some of the key legal and operational issues arising as a result.

Structural issues

There are two primary sources of contention between lenders and fund managers: (a) control and (b) the use of credit at different levels, or layering.

Control: Many banks are able to offer better lending rates or fewer investment guidelines where they have full control of the underlying assets by being registered as the owner of the underlying fund shares. This is predominantly on the basis that it significantly reduces the risk of fraud on the part of the FOHF provider and the fact that in the event of any dispute the old rule that possession is nine-tenths of the law may have some application. Whilst this commercial gain may be tempting, product providers may find that the practical objections outweigh that advantage:

• Underlying fund managers like to see the FOHF manager as the investor – they do not generally want to deliver reports to a bank with whom they have no relationship.
• While the FOHF manager would like to limit the bank’s contact with the underlying manager, this may be hard to control where the bank owns the underlying shares.
• Switching assets in and out of the bank’s control requires dependence on the bank’s middle office which may not be as reliable as is required. It can be challenging to explain to a FOHF portfolio manager that an investment deadline was missed because the bank failed to complete the paperwork.
• Transferring assets to/from the bank may re-start the clock where there are lock-ups and/or redemption penalties.
• Granting asset control to the bank may mean taking some credit risk on the bank and almost certainly gives the bank a stronger position upon an event of default.

The appropriate use of custodians, and in particular those with some form of on-line account system, may well allay some of the control concerns. Banks are more likely to be comfortable with a charge-based security structure where they are able to monitor the portfolio decisions on-line from a 3rd party service provider. However, there is often no easy answer to the conflict between the bank’s desire to have positive clearance over all trades and the FOHF managers’ desire for limited negative clearance (ie. the bank does nothing unless the trade causesa breach). As banks may have a legitimate need to prevent losses arising from fraud, the only solution here is for the FOHF manager to develop sufficiently robust operational systems to reduce the likelihood of such fraud occurring. Product providers with a strong focus on institutional fund management are more likely to have developed such systems and may also have obtained ISO or similar certification.

Layering: FOHF providers often operate with an open-architecture approach, with multiple style and strategy-specific offerings from which clients can ‘pick and mix’ as they see fit. It is also common to have liquidity facilities at the style/strategy fund level to bridge the timing gap between redemptions and subscriptions. As a result leveraged diversified offerings often invest through this architecture which results in liquidity facility providers being structurally senior to the leverage provider which may raise some concerns.

• Using liquidity facilities for liquidity is acceptable (and even desirable), using them for permanent leverage may not be. The difficulty lies in distinguishing one from the other. For example, where large inflows are anticipated on say, 15 February, the FOHF manager may wish to use a liquidity facility to subscribe in funds with annual dealing days on 1 January – it is debatable if this is bridging or leverage.

• As the extent of bridging utilisation is fluid and unknowable, the leverage provider must decide how to include these in its analysis and the very conservative approach is to assume full utilisation which will increase the effective level of leverage within the structure.

Financing structures

A range of different structures have been developed:

Loan/Credit Facilities: a rare beast in the leverage world because of the capital charge treatment though still suitable for liquidity facilities.

Total return swaps/accreting strike options: These were once the main tool for delivering leverage to guaranteed products. Each involves a product selling underlying shares to the bank in exchange for which the bank makes a payment (on which the fund pays interest) and agrees to sell the shares back upon maturity at which point any value change accrues to the fund. As the bank has to hold the shares as a hedge, the bank is in control which brings with it the issues for the FOHF provider discussed above.

Variable Funding Note (VFN)/Private CFO/CLO: Note issuance structures solve the issue of credit and operational risks of the bank holding the underlying assets as a hedge: the bank receives a floating charge and the fund/SPV issues redeemable notes, thereby allowing flexible leverage.

With some banks, any security concern can be allayed by using a custodian – this suits the product because the custodian is adept at share transfers and suits the bank because they are happy that they have some control over the assets. Note, structures have an additional significant benefit of allowing the banks to offload some, or all, of the funding obligation to the non-bank community, potentially using a CDS. While this may reduce the role of the bank to that of arranger and risk manager, it may also make the trade more profitable from a capital perspective and does not eat into lending capacity. This structure therefore has the ability to connect entities with risk appetite and experience (the investment banks) and those with significant balance sheets (CP vehicles, retail banks, insurers).

Public CFO: As for Private CFOs, but with a public rating and debt tranching. Issuing AAA rated debt is helpful in providing access to new channels, but can result in relatively high structuring and legal costs. Nevertheless the early CFOs issued may have reduced market spreads on all leverage deals. They may also have encouraged other banks to enter the leverage market and use the public offerings as a basis for internal ratings, which had the effect that public CFOs as a means of raising debt became redundant.

The involvement of the rating agencies may have contributed to the acceptance of hedge funds as an asset class, but the operational reality of involving rating agencies and multiple debt providers can be challenging: the rated CFO structure is static, the hedge fund industry is not – the consequence is that the CFO vehicles may become outdated and operationally restrictive. These structures will, nonetheless, maintain a place in the market for investors looking for highly leveraged exposure to FOHF rather than as a pure financing tool.
Operational issues: reporting & transparency

There is an ongoing conflict between the traditional opacity of the hedge fund industry and a lender’s desire for full transparency. This balance reflects wider trends in the industry with the emergence of hedge funds as an asset class being disturbed by underlying manager blow-ups.

Product providers should recognise that some level of reporting is inevitable and should embrace the challenge of implementing levels of transparency, without impacting essential business operations. Key issues in this area include the following:

• Confidentiality: restrict the flow of information on a need-to know-basis, or with particularly sensitive items, limit to specified individuals or teams. This may be a particularly important issue on note issue structures where syndications may occur.

• Manager data: be sure to prohibit manager contact and avoid position or detailed risk reporting, the latter because of its onerous and ongoing nature, the former because it is likely to be a major issue for a product provider.

• Consent: ensure that written consent is obtained for any third party disclosure.

• Resources: producing weekly and monthly portfolio estimates, together with investment guideline compliance reports can be operationally onerous: it is important to ensure that the right resources are available to comply and that any non-compliance results in a trigger event only after the expiry of a grace period.

• Extent: some banks try to extend the reporting obligations to include all underlying manager’s service providers, directors, affiliates etc. Whilst there may be a legitimate need for such detail, it can be very difficult to comply with this level of reporting.

Conclusion

Until recently a perennial question in relation to hedge fund financing has been ‘will it always be there’ or will hedge fund blow-ups and scandals result in a massive credit crunch as banks exit the sector en masse? In practice, 2006 was something of a test year which showed that, notwithstanding a string of high profile and substantial collapses, properly structured debt arrangements at Structured Product/FOHF level were robust enough to withstand the knock-on effects. In addition, it showed that the credit appetite of banks in this sector remains as strong as ever, albeit with perhaps a keener sense of the risks of exposure to individual strategies and the priority of the prime broker in the security chain.

A summary of this article appeared in the AIMA Spring 07 Journal.