Margin Lock-Ups

Ask and ye shall receive

Jerome Ranawake, Freshields Bruckhaus Deringer LLP
Originally published in the September 2006 issue

Prime brokerage services are an essential but often misunderstood part of the hedge fund industry. Prime brokers are full-service broker-dealers who act as a clearing and settlement facility for their customers' securities transactions, and a custodian for their customers' securities and funds. Prime brokerage involves the prime broker, the executing broker and the customer.

Competition among prime brokers for hedge funds' business has heated up significantly as the industry has expanded, particularly as the larger and more sophisticated funds have established multiple prime brokerage arrangements for different products to capitalize on pricing discrepancies.

One of the most important consequences of this increased competition has been the increased availability of margin lock-ups to hedge funds from prime brokers. Hedge funds should take advantage of these types of facilities and negotiate contractual terms that protect them from being closed out in times of market turmoil.

Margin lock-ups "lock in" the prime broker's margin and collateral requirements for a specified period of time (between 30 to 120 days depending on the size and creditworthiness of the hedge fund client and the volatility and diversity of its trading strategy). The lock-up prevents the prime broker from altering pre-agreed margin requirements or margin lending financing rates, or demanding repayment of margin or securities loans or any other debit balance.

Lock-up termination events

As one would expect, a default under the base prime brokerage documentation will also cause the margin lock-up to terminate. However, because margin lock-ups increase prime brokers' exposure, prime brokers often seek to impose additional margin lock-up 'termination events', such as net asset value decline triggers, a removal of key persons and a change of managing entity.

In the US, some prime brokers have controversially attempted to impose a lock-up termination event for the indictment or conviction of any officer of the relevant fund or its investment manager for any felony in connection with their management activities.

Hedge fund managers have strongly resisted the introduction of this provision because they are concerned that they could undeservedly fall within the ambit of a broad attack on hedge fund industry practices by State prosecutors such as the New York State Attorney General Elliot Spitzer.

Prime brokers also seek to build in bespoke issuer and sector concentration and liquidity requirements, the breach of which will cause the margin lock-up to terminate. These vary from fund to fund based on the relevant fund's trading strategy. The fund should seek to ensure that if there is a breach of these requirements, the lock-up only terminates with respect to the non-compliant positions that caused the breach, rather than in its entirety. Any increase to the margin requirement percentages applicable to such non-compliant positions should be capped at 50% of the current market value of such positions. If a prime broker seeks to impose concentration and liquidity requirements that relate to the positions of more than one fund managed by a single hedge fund advisor, the advisor should be wary of the potential issues relating to its fiduciary responsibility to the investors of each individual fund which may result.

Negotiating margin lock-ups

It is critical when reviewing any margin lock-up documentation not to negotiate the document in a vacuum. One obvious but often ignored point is that the lock-up annex should be reviewed inconjunction with the base documentation to which it relates which may have been negotiated at a time when the relevant hedge fund was a substantially weaker credit. More often than not, such a review will reveal provisions in the base documentation that are fundamentally inconsistent with, or would allow the prime broker otherwise to circumvent, the objectives of the margin lock-up. Issues to look out for include the:

  • Ability of prime broker to impose in its discretion minimum net equity requirements above the applicable SEC or other regulatory requirements;
  • Ability of prime broker to impose position limitations beyond those required to comply with applicable exchange or regulatory requirements;
  • Any interest, fees, charges or other expenses payable by the hedge fund client that are not expressly made subject to the lock-up (other than third party fees and charges passed through to the client by the prime broker);
  • Ability of prime broker unilaterally to terminate or amend the prime brokerage documentation; and
  • Ability of prime broker to modify any of the specified types of acceptable margin or applicable haircuts relating thereto.All of the above should be subject to the same lock-up prior notice period that applies to the margin requirements themselves in order to ensure that the prime broker is not able to circumvent the terms of the lock-up. Other issues frequently negotiated include:
  • The parameters determining which positions are eligible for the lock-up;
  • The ability of the hedge fund to substitute equivalent portfolio positions during the prior notice period (i.e. even after the lock-up termination has been given) to which the locked-in margin requirements will apply during the prior notice period (generally, following notice of termination of the lock-up, the locked-in margin requirements will not apply to new trades entered into during the prior notice period);
  • The nature of, and valuation haircut percentages applicable to, pre-approved types of margin securities.

Most hedge funds focus on lowering the agreed fee rates of their prime brokers and have not spent enough time reviewing the hidden costs of prime brokerage such as discrepancies in collateral price quotations. Indeed, the lack of transparency about the hidden costs of their services and the inequitable treatment by certain prime brokers of different clients have led some industry observers to predict a client lawsuit against one of the major prime brokers.

The SEC has indicated that it will continue to use its authority to examine the procedures of broker-dealers, and the increased involvement of institutional fund managers and pension funds in the hedge fund industry may result in increased scrutiny of prime brokerage costs, all of which should have a positive effect on the industry.

More sophisticated hedge fund managers are increasingly interested in achieving working capital efficiencies by ensuring appropriate market pricing for margin financing and securities borrowing and identifying opportunities to optimize their collateral. With this in mind, many have hired agency collateral trading managers such as S3 Partners who interface between their hedge fund clients and prime brokers, taking advantage of the anonymity of their clients when gathering information and capitalizing on the fact that certain assets are worth more to prime brokers than others in the financing markets at different times.

Margin lock-ups should be a key tool in helping hedge funds to achieve the working capital efficiencies they need to maximize returns to their investors. Remember, if you don't ask for a margin lock-up you won't get one.