Hedge funds are being heavily impacted by Basel III putting a strain on prime brokerage relationships and sources of finance. Who will the hedge fund community turn to now?
When the Basel Committee on Banking Supervision (BCBS) was formulating the Basel III provisions, a large proportion of hedge funds felt this was simply an issue for banks to deal with. Its full implications on the $3trn hedge fund industry were not completely realised. This mind-set was understandable. Regulation of the hedge fund industry was in full-swing and managers simply did not afford much attention to Basel III. At the time, custodians and prime brokers were also ruthlessly chasing hedge funds for business. The default of Lehman Brothers had exposed hedge funds and their clients to the dangers of single counterparty risk, and as such managers were being told by institutional clients to spread their counterparty risk across multiple prime brokers.
There were even reports of bulge bracket banks chasing client mandates as low as $10m in Assets under Management (AUM). This courtship ended when Basel III was properly digested by the banks. It is not rash to suggest that the impact of Basel III on some hedge funds will be far greater than other major regulatory reforms including the Markets in Financial Instruments Directive II (MiFID II), the Alternative Investment Fund Managers Directive (AIFMD) or the introduction of mandatory clearing of over-the-counter (OTC) derivatives instruments.
At the heart of Basel III lies capital requirements. Liquidity Coverage Ratios (LCR) force banks to hold high quality liquid assets (HQLA) that are sufficient to withstand a 30 day market stress event. HQLA are restricted to cash, sovereign bonds, central bank reserves, a handful of equities and a limited number of high-grade corporate bonds. Prime brokerage has historically relied on maturity transformation whereby they provide hedge funds with financing for 30 days or more, but funded themselves through the short-term repo market or internalisation by netting off across their client base.
“This is a process whereby the prime broker will offset the assets of clients’ long securities against another clients’ short positions. The ability to offset trades has been severely curtailed under Basel III, and this could hinder financing of certain hedge fund strategies,” says Jerry Lees, chairman of Linear Investments, a specialist broker in London.. A briefing by the Alternative Investment Management Association (AIMA), the hedge fund industry group, highlighted the impact of LCR had been felt where prime brokers moved away from funding positions from an overnight basis to a 30-day financing term model. “The general consensus at the event was that any increase in financing cost has been absorbed by the prime brokers rather than passed onto clients,” read the AIMA briefing.
The other component of Basel III is that it seeks to reduce liquidity mismatches and banks’ over-dependence on short-term funding through its Net Stable Funding Ratio (NSFR) provisions. Put simply, the NSFR is a ratio of the Available Stable Funding (ASF), or capital and liabilities that are deemed to be reliable for one year, and the Required Stable Funding (RSF), which are assets or off-balance sheet exposures that need to be funded by the entity in question.
Compliance with NSFR means that the ratio between ASF and RSF should be 100%. As such, securities financing trades with certain financial institutions will hold higher capital requirements. A briefing by the International Capital Market Association (ICMA) points out that all reverse-repo transactions with non-banks, such as hedge funds, with less than one-year maturity would require the provision of stable funding against 50% of the value of the reverse-repo. If the maturity is in excess of one year, this increases to 100%. As such, RSF will be higher for providing financing to highly illiquid hedge fund strategies.
The third aspect of Basel III surrounds the leverage ratio (LR). LR will force banks to hold sufficient levels of Tier 1 capital to ensure their LR does not fall below 3% of non-risk weighted assets, or that such assets and commitments do not exceed 33 times the regulatory cap. Furthermore, LR will gross up securities financing transactions.
Most financial institutions are cutting back on risk assets to achieve or even exceed the ratios demanded by regulators. A recent Bank of England (BOE) paper noted UK banks have increased their Tier one capital ratios by four percentage points since 2011 to around 11%. This is well above the ratio demanded by regulators of even the largest Globally-Systemically Important Financial Institutions (G-SIFIs).
All of these Basel III requirements are going to profoundly impact prime brokers’ return on equity. As such, it will make them more selective in terms of the hedge funds they work with and provide financing to. “Prime brokers are reassessing and re-evaluating the hedge fund managers which they have relationships with because of Basel III, and this is only likely to continue,” comments Peter Coates, chief executive officer at Omni Partners, an investment manager in London.
Some start-up managers are finding it a struggle to be on-boarded by bulge bracket primes. “I have heard anecdotally that start-ups running between $75 million to $100 million have struggled to find a prime broker. As hedge funds are balance sheet intensive, the prime brokers really must have conviction that clients will be successful,” comments another expert, who did not want to be named.
Any restriction on financing will have an adverse impact on hedge fund returns, particularly those which are illiquid or heavily reliant on leverage. Analysis by the prime brokerage business at Barclays in 2012 estimated these restrictions on financing would result in the average hedge fund seeing a drop in returns of between 10 basis points (bps) to 20 bps. Some strategies would be hurt disproportionately, most notably fixed income arbitrage which typically employs leverage of 13 times its Net Asset Value (NAV). Barclays estimated fixed income arbitrage strategies could therefore see a decline in returns of 40 bps to 80bps.
Funds overboard
A 2015 hedge fund survey by Ernst & Young (EY) found that 41% of distressed debt managers and 32% of fixed income/credit managers had seen their prime brokerage fees increased. Others, however, believe that vanilla or liquid strategies which do not consume much balance sheet, will probably not be that impacted. “A fixed income manager will face more financing restrictions than perhaps a market neutral manager, for example,” comments Martin Visairas, global head of capital introductions at Citi.
Papers published by Citi and J.P. Morgan both concur prime brokers will have to be more careful about the financing they provide to certain hedge funds. Indeed, several high-profile banks have scaled back the number of hedge fund clients they work with because of balance sheet constraints. Credit Suisse has culled clients while it was revealed in January 2015 that Bank of America Merrill Lynch terminated 150 hedge fund client relationships, particularly those employing quantitative or computer-driven strategies. It was also reported in the summer of 2014 that Goldman Sachs had started charging hedge fund managers more for financing and introduced monthly fees on firms which maintained untapped credit lines with the bank. Deutsche Bank too is engaging in a strategic shrinkage and has confirmed there will be “selective reinvestment” in prime brokerage operations.
Being exited by a prime broker could result in redemptions as some investors might view it as a loss of confidence in the viability of the manager. “The type of managers which prime brokers are reviewing business relationships with have historically tended to be those which have suffered adverse performance, or which have not grown their Assets under Management sufficiently. A number of prime brokers will now view these managers as a balance sheet cost as opposed to a meaningful revenue generator,” says Coates.
Hedge funds are going to have to evolve to deal with this changing prime brokerage relationship. Best practice since the crisis has dictated that hedge funds multi-prime. A typical hedge fund with $5 billion will usually have six or seven prime brokerage relationships. This pressure on financing will probably result in such managers scaling back the number of prime brokers they have to three or four. It is crucial firms get the balance right between accessing favourable financing terms from prime brokers and managing their counterparty risk appropriately.
“Some prime brokers are asking hedge funds with balance sheet intensive strategies to give them more execution business to compensate them for the added costs of Basel III. A lot of prime brokers simply do not want to have hedge fund cash parked with them as it will eat into their balance sheet as hedge fund cash – unlike retail deposits – is viewed as unstable and prone to flight in volatile markets. Under Basel III capital requirements, hedge fund deposits are subject to higher capital requirements. As such, certain hedge funds could be forced to reduce the number of prime brokers they use,” says Peter Northcott, executive director at KB Associates, a consultancy.
Explaining this to investors could be challenging, a point made by Coates. “Hedge funds must be transparent about the evolving prime brokerage landscape. If it is explained coherently and honestly to institutional investors, they will be sympathetic. But it is critical managers start these discussions now,” says Coates.
The rise of the minis
However, it is unlikely a return to single counterparty relationships will emerge. “A return to a single prime environment is not going to happen. Most investors allocating into hedge funds nowadays are institutional and comprise of large pension funds and investment consultants. As a result, there is an increased focus on governance and these entities will not tolerate hedge funds having all of their eggs in one basket as many did prior to the financial crisis. I believe large hedge funds will reduce the number of primes. The focus on hedge funds now is to ensure they optimise their prime brokerage relations,” says Visairas.
Alternative options are emerging. Mini primes or introducing brokers were for the most part written off around 2010 and 2011 as bulge bracket prime brokers went after their clients or terminated custody and clearing relationships with them. However, the mini prime model is enjoying a renaissance courtesy of Basel III. Boutique prime brokers have been winning mandates from small to mid-sized hedge fund managers, who are either being exited or ignored by the large banks. Mini primes argue they offer a more bespoke service to smaller and mid-sized hedge funds, particularly around capital introductions as opposed to the commoditised offerings they will typically receive from bulge bracket banks. Furthermore, a number of larger managers are reportedly looking to mini-primes as a cost-effective mechanism to spread their counterparty risk as a means to reassure their investors.
“Specialist brokers offers a more personalised and bespoke service to smaller and mid-sized hedge funds. Due to the implications of Basel III, a number of bulge bracket banks are simply ignoring smaller managers. This is providing an opportunity for specialist brokers. We can provide a lot of the services of a bank but in a more cost effective manner. Simultaneously, service offerings such as capital introductions are more tailored to the needs of the end client,” says Lees of Linear Investments. Lees also highlights that a number of larger managers, which have scaled back the number of prime brokers they use, are also looking to specialist brokers as a cost-effective mechanism to spread their counterparty risk as a means to reassure their investors.
Non-bank sources of financing could also emerge in what may prove to be a lucrative market. “Financial institutions which are not subject to Basel III capital requirements could start providing financing to hedge fund managers if banks continue their retreat from financing,” acknowledges Coates. One of the likely candidates could be private equity. The asset class is sitting on record levels of dry power, which Preqin, a data provider, estimates to be at $1.4 trillion. The figure among European private equity managers is around $137.4 billion, up from $117 billion in 2012.
The overheated equity markets are a major factor behind private equity’s reluctance to enter into deals. As such, their investors are complaining that they are paying fees just to watch their cash sit idly by. Private equity could potentially start lending out surplus capital to hedge funds in what could be a consistent revenue generator. This would certainly appease their restless institutional client base.
Fund-to-fund lending
Another source of hedge fund financing could be from other large hedge funds. A number of large hedge funds have bolstered their treasury departments, often through hires from banks. While most managers are improving their treasury operations to optimise their funding and counterparty relationships, some may look to lend out unencumbered assets to other managers. Given the lacklustre returns of late at hedge funds, having a consistent source of fee income through financing would be a much welcome respite. One institutional investor, speaking at the GAIM Ops Conference in Dublin in October 2015, said prime brokers could act as intermediaries between hedge funds lending out assets and hedge funds borrowing them.
There are, however, obvious drawbacks to this. Very few private equity and hedge fund managers will possess the technology and internal infrastructure or personnel to provide such a capital intensive service as financing. “Any alternative provider of financing would need to invest in the correct infrastructure and people before undertaking this work,” says Coates. Building this infrastructure will be time-consuming and costly, a point made by prime brokers.
It could also expose these firms to excessive risk, particularly if the borrower hedge funds defaults. Whereas banks will have sufficient capital reserves to withstand such market shocks, a hedge fund or private equity manager may not. This will ultimately introduce another element of counterparty risk. Furthermore, if regulators start seeing private equity and hedge funds acting like quasi-investment banks, it could subject them to further regulatory oversight, or worse Basel III type capital requirements.
But how prepared are hedge funds for the changes that will come under Basel III? A survey published in January 2015 by State Street of 235 hedge fund professionals found 29% believed Basel III would significantly increase their firm’s cost of financing, while 42% said it would not, and 29% stated they were unsure. The same survey found that 37% of managers expected significant changes to the way in which they worked with service providers including prime brokers.
Alarmingly, 26% said they did not know if they would make changes to these service provider relationships.
“The level of awareness among hedge funds about Basel III is mixed. Some of the large players have been giving Basel III a lot of thought while others have put their heads in the sand. The implications of Basel III on the hedge fund industry will be massive and now is the time for managers to start re-evaluating their prime broker relationships and exploring mechanisms by which they can secure steady, stable financing so as to ensure returns stay strong,” comments Lees.
Hedge funds are going to face a number of challenges as Basel III takes effect. Prime brokers will become more selective over the managers that they work with. This could disadvantage smaller managers. As such, these firms will need to find alternative providers of financing otherwise they could find themselves struggling to make returns or sustain their businesses.