Hedge Fund Financing: Still in ‘Prime’ Position?

February 5, 2015

Equity financing (in a Capital markets banking sense rather than a company raising funds by selling its equity interest) refers simply to the lending of money or securities to financial institutions (normally hedge funds) in exchange for appropriate collateral (normally equity products). Typically a capital markets equity finance division will include stock borrow/lending, equity swaps, prime brokerage margin financing and structured equity financing. Often these three core businesses are referred to in marketing terms to institutional clients as ‘Prime Services’. Custody, clearing, access to capital, and research are also normally part of the offering.

These collective financing businesses have one key requirement to be profitable: access to money. Either from the bank’s own treasury balance sheet or a third party via re-financing.

Prime Brokerage (PB) used to be a simple business for banks. Borrow money from a seemingly never-ending internal balance sheet at relatively low cost, add a juicy spread and on-lend to hedge fund clients in exchange for the appropriate amount of collateral to keep the bank safe should the hedge fund become unable to pay back the loans. As long as the collateral was correctly priced and its risk and liquidity assessed properly on a daily basis, they couldn’t lose. What could be easier?

In awe of the huge revenues and profits generated by the original bulge bracket US banks, most notably Goldman Sachs and Morgan Stanley during the 1990s, over the last 15 years in Europe and Asia nearly all Tier 1 Banks have entered the marketplace with their own offerings. Hundreds of millions of dollars have been spent on creating and maintaining infrastructure, hiring huge teams and creating global service models to service the enormous amount of hedge funds who themselves were starting up at an extraordinary rate. Global Prime Services staff numbers at the Tier 1 Banks during the mid 2000s involved anywhere from 200 to 400 people at each bank, with thousands working in the business across the industry.

Or at least that was the picture before the 2007-08 financial crisis. The sudden increase in borrowing costs, subsequent collapse of Bear Stearns and more notably Lehman Brothers changed the PB landscape forever. Until that point there was very little consideration by hedge funds of the counterparty risk of their PB. After all, how could these huge global investment banks making billions possibly fail? Well fail they did, and in the case of Lehman a huge issue related to the holding of client collateral by PBs was uncovered. Gone were the days of the relatively simple business outline above. Instead, the cost of the PB borrowing from its parent bank’s balance sheet multiplied 10 or 15 fold, and those costs could only partially be passed onto the hedge fund clients, who themselves were enormously squeezed for capital. To stay profitable the PBs were forced to do something that had only been done previously to cream extra revenue, but was suddenly a necessity for the business to survive: ‘rehypothecation’ of client assets.

Rehypothecation of client assets is the name given to the practice of the PB on-lending the client collateral (for the PB margin loans normally) to a third party for refinancing. This third party would be a bank with greater access to balance sheet and as such would lend the money back to the PB for on-lending to their clients. As these sources were much cheaper than internal treasury functions at the PBs this was the only way to survive. For almost all full-service PBs today, this is the only way to survive.

Back in 2008, rehypothecation was not as commonplace as it is today. To carry out the activity properly and in a controlled manner, a complex infrastructure is required at the PB where the client collateral is constantly assessed for suitability and liquidity, as is trading activity on those positions, and the legal limits imposed on the PB for rehypothecation. Normally, and increasingly, clients would insist on PBs only having access to stock for rehypothecation as percentage levels of their borrowing (sometimes known as indebtedness). This way assets are only rehypothecated by the PB where there is a need to finance borrowing. It sounds like a solution to the PB’s problem of not being able to use bank balance sheet, but collateral suitability, legal limits and active trading normally mean that it’s not the perfect solution for a completely ‘self-financing’ business, albeit it does keep them in business.

But we digress. When Lehman Brothers failed so spectacularly in 2008, the practice of rehypothecation was brought to the attention of hedge funds and their investors, and suddenly thrown centre stage during the bankruptcy proceedings. Until that point the focus had been on the banks having enough collateral for their lending activity. In this case however, it was the hedge funds wanting their own collateral assets back.

At the time, a typical PB set-up was for the hedge fund client to be offered Custody Services for free, and as such the hedge fund would place all their assets for a particular fund (if they had one PB) in that custody account, even if they were not needed for financing. The PB legally owns the custody account while the hedge fund still beneficially owns the securities. As such, the PB has the right to rehypothecate the assets – depending on the legal agreement – normally in excess of indebtedness, and unlike the US there are no regulatory restrictions. In 2008, the percentage levels were not a huge consideration for the hedge funds, and as such Lehman and other PBs were able to rehypothecate many of the assets given to them as long custody positions by the hedge funds. Many hedge funds had contractually agreed with their PB that an unlimited amount of their long fund assets could be rehypothecated, normally in exchange for lower overall funding spreads.

In short, when the hedge funds came looking for their long fund assets in the Lehman PB custody accounts following its bankruptcy, they just weren’t there. They had been rehypothecated and were sitting with multiple third parties. This wasn’t particularly good news for the hedge funds. The fact that under British law there was no legal asset protection (unlike 15c3 in the US) was a further issue. Ultimately most of the assets were returned to the hedge funds. This however took years rather than days, and many of the hedge funds did not survive during this period.

This single event changed the way that hedge funds and other institutions looked at PBs. In a bid to reduce the counterparty risk of the PB, there was subsequently a trend towards hedge funds having multiple PBs to diversify risk, looking to US PBs to offer international PB services from their US legal entities, restricting rehypothecation (with close monitoring/reporting of this activity), and client money lock-up. This in turn has increased the costs for PBs. This, in conjunction with the necessity to refinance all positions via rehypothecation, has now made it increasingly difficult for PBs to return the huge profits that were once so prevalent.

So latterly the equity finance business hasn’t looked in such a ‘prime’ position because all of the constituent businesses require funding and balance sheet access, and inventory of the PB business to be profitable. PBs in recent years have focussed on improving efficiency, significantly reducing costs, finding other funding sources and cutting ties with unprofitable clients with unfundable assets. Unfortunately for broker/dealer-style PBs there doesn’t seem to be any sign of cheaper funding in the near term. However at some other banks, custodians and asset managers, balance sheet is accessible and still relatively cheap. Some of these institutions are looking to enter the market, and have done so, with enhanced custody financing type offerings.

It remains to be seen whether these new entrants will continue to enjoy low costs of funds, and as such, see some of the profitability associated with the pre-2007 era, but it’s worth watching this space.

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