Prime Brokers and Hedge Funds

Who is wearing the trousers now?

SARAH WILLIAMSON & LEE MASTERS, HEDGEMASTERS

Until recently, large investment banks with significant prime broker units were happy to allow some elements of the business to run as a ‘loss leader’ for the accolade of having the big hedge fund names as their clients, particularly if they could claim sole prime broker status. In addition, the nature of the prime business world meant that no hedge fund could lay claim to controlling the relationship.

There are no screen-based pricing mechanisms to refer to in orderto prove that the best price or lowest cost has been attained, and many a hedge fund has been happy to pay the quoted price in order to maintain their ‘special relationship’ with their prime broker. Little concern was paid by the hedge funds to the credit status of their prime broker, or the control environment within which it operated, with more emphasis being placed on the importance of the relationship. The main problem a hedge fund could cause its prime broker was to move some or all of its positions to another bank and implicitly sully its reputation. The events at Bear Stearns have taught us that the cost can be far higher; the fire-sale of a venerable bank to one of its competitors for a fraction of its previous market value.

In a new twist, it is now clear that a key contributor to Bear Stearns’ problems was a significant and catastrophic withdrawal of hedge fund assets, both cash balances and securities, from the prime brokerage unit. Under the vast majority of prime broking agreements, re-hypothecation rights are normally assumed by the prime brokers for a significant percentage of positions of their hedge fund clients. These rights mean that these positions then become a vital part of the life blood/working capital of banks with large prime brokerage units. Any dramatic reduction in these could have a devastating knock-on effect for a bank which needed this inventory in order to help collateralise its counterparts. An effect fatally amplified when coupled with the current global credit crunch. Instead of simply covering their requirements in the interbank market in order to maintain liquidity, Bear Stearns was forced to seek emergency funding, leading to the intervention of the Federal Reserve in the form of an underwritten take-over by JP Morgan.

So, now it is also imperative that hedge fund managers scrutinise the credit rating of their counterparts. Using Bear Stearns as an example, if managers felt uncomfortable with the bank’s ability to remain solvent, clearly it was in their interests to move their business. Otherwise they would run the risk of having their assets frozen in the event of default by their prime broker, with the added nightmare of becoming a creditor to a bank in administration.

The ‘special relationship’ that we have written about before, all too often based on blind trust and the relationship of a hedge fund manager and his alma mater, cannot continue. In order to protect their investment, investors must demand that hedge funds and their prime brokers have proper robust controls, both legal and otherwise, on an on-going basis.

This sea-change in the relationship between hedge funds and their prime brokers will result in changes to the ways in which they conduct themselves, particularly in the following areas:

Collateral

The collateral management function at some prime brokers will become vital to their continuing in business. Key issues need to be addressed such as:

* Acceptable collateral:This will only be of the highest quality. There will be increasing reluctance to accept securities as collateral for certain positions and for stock loans; why increase your market and foreign exchange risks? Even some currencies may become more desirable than others; with the traditional dollar becoming increasingly unstable, and even unwanted by investors, some prime brokers may decide to take only Euros, say, or Swiss francs. Let’s face it, if the supermodel Gisele wants Euros, why wouldn’t UBS? This will further increase the complexity of trades for hedge fund managers as the foreign exchange element may also need to be hedged.

* Efficient mark to market:The prime broking units must ensure that they have the capability to mark to market efficiently and on a daily basis. In a rapidly moving market, margin can be quickly eroded. This can be used as a selling point to their hedge fund clients as in a falling market they would benefit from swift marking to market by ensuring that they are not over-collateralising.

Margins

Margins will continue to increase, which means a reduction in the leverage available to hedge funds. Cross margining of some products might be withdrawn, leading to increased margin calls. It is likely that a wider range of securities will have to be paid for in full by the hedge fund. Again, larger hedge fund managers should look to lock in their margin terms, so they have enough time to position themselves if and when margins are changed by their prime brokers.

The type of securities traded will also be of paramount importance to the hedge fund manager when margins are changing. Equity long/short funds will fare better than their fixed income and macro counterparts, as they typically employ far less leverage. In addition, equities are far easier to price and much more liquid than some of the more esoteric OTC and thinly traded securities and transactions entered into by the fixed income and macro funds.

Size matters

Competition between prime brokers will undoubtedly decrease in the short term. This will be due both to the mindset of ‘better the devil you know’ until the dust has settled, and a flight to quality as better rated prime brokers will benefit from hedge funds moving their portfolios over to them. This could lead to an even more divided industry, with two or three firms dominating the stage. Similarly, smaller, less well rated and less well known prime brokers will suffer. It is well worth checking credit ratings as even the large established firms may not be quite what they seem. For example, the prime broker unit may be a separate legal entity to the parent bank, which would have many ramifications in the event of a default. This same principle will apply to hedge funds resulting in hard times for the smaller funds with the double impact of fewer new investors and an overall cost increase from nervous and/or more powerful prime brokers.

Cash is king

It is certainly true that the lucky cash-rich hedge funds are well placed to buy up assets at below market value from distressed hedge fund managers needing to make an urgent margin call. For example, we saw Citadel buying the assets of Amaranth Advisors energy fund in 2006 and Sowood Capital Management in 2007, when the stricken hedge funds struggled to stay afloat as their investments went against them. This trend for hedge funds to provide liquidity to, and pick up ‘cheap’ assets from troubled managers will continue.

Stock loan

The situation for the long only asset managers should not be dire since they already have collateral in excess of the loan market value, which is marked to market daily. For some of these custodians active in the stock lending market the priority will be to reduce their credit exposure to less well-rated prime brokers. Stock loan fees will also rise as a result of tightening of lending criteria, and a change in the risk/reward ratio. Collateral requirements for stock loans may also change, both in quantity and quality, which will again reduce the leverage available to hedge funds with large short books. Prime brokers will pass on any increases in their costs due to these more stringent third party collateral requirements to their hedge fund clients, again resulting in higher fees overall.

Credit reviews

Credit risk management departments will require full disclosure from all clients: many banks already have this policy in place, but it seems unlikely that all do since Carlyle appears to have managed over 30 times leverage, a scenario which should not have been possible under most bank’s lending, margin requirements and procedures.

Segregated accounts

Inevitably this will raise the issue of segregated accounts; larger hedge funds could well demand that their cash is kept in segregated accounts, rather than co-mingled with that of other hedge funds, and indeed the balances of the prime broker itself. This will increase administrative burden on prime brokers and these resulting costs will again inevitably get passed on to their clients.

Hedge fund start ups

New hedge fundswill find it very difficult to get a reasonable prime broker service, or even an offer of one. We have seen offers withdrawn over the past two months to start-up funds by their chosen prime brokers. In addition, the lack in confidence of potential investors will add to the struggle to set up and survive the crucial first few years of running a fund.

Administrators

The independent valuation of a hedge fund portfolio by their administrator is a key control from an investor’s viewpoint. The risk of one of the administrators being sued out of business because of a defaulting fund must now be a very real concern for them.

What does the future hold?

Unfortunately, it would take a brave person to put their head above the parapet and say the bad news is behind us. The polarisation of the business will inevitably put pressure on some of the smaller, less well capitalised investment banks who generate their supply of cash from prime broking style transactions including swaps and collateral driven trades. Hedge fund investors and managers must adopt a far more cautious approach to their investment bank. Given market conditions therefore, further casualties should be expected, even among some household names. We would also hope to see some positive outcomes. For example, the lack of confidence might provide the impetus required in order to clear the scandalous backlog of OTC transactions in the business as banks struggle to identify all open positions with all their counterparts.

Who’s wearing the trousers now?

Obviously there has been a change in the balance of power between hedge funds and prime brokers with the larger and more established funds being able to demand more favourable terms than ever before.

Does this, however, put them in charge? No. What the current market crisis should bring about is a back-to-basics mindset in the market, based upon professional controls with regard to the availability of credit. As with all of these situations, the party wearing the trousers with the biggest pockets must be the lawyers. After all, financially, they never lose. They will find it hard to suppress their smiles – attributing fault to market events will be as much fun as the Macca vs Mills divorce!


About HedgeMasters LLP

Hedgemasters works with hedge fund managers to save them money, using an innovative no-win, no-fee charging structure. It analyses operations and looks after the costs, leaving hedge fund managers to concentrate on their core business of producing returns. Quick savings can be made across all areas; front, middle and back office.


Biology

SARAH WILLIAMSON

Sarah Williamson founded HedgeMasters in 2002 with Lee Masters. Between 1998-2002, she spent five years as Director within the Hedge Fund Services group at UBS. She has also worked at the then SBC Warburg and NatWest Securities on the equity finance trading desk. Williamson has also worked at Lehman Brothers prime brokerage in London, and Cargill Financial Services.

LEE MASTERS

Before starting HedgeMasters in 2002 as a founder partner, Lee Masters was Chief Operating Officer with CSFB’s European Financial Control division. Prior to joining CSFB, Masters worked as the project manager in the design and implementation of a securities lending risk assessment system. Previously, she worked at NatWest Securities in London and Hong Kong, on the equity finance trading desk.