Over the course of the last decade, bank lending to hedge funds and hedge fund listed 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, we take a product provider’s look at why leverage is typically used, how banks approach hedge fund lending and some of the common structures used.
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 European Medium Term Notes (ETMN) 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 e.g. trading on margin as part of a futures-based Commodity Trading Advisor (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/allocable 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.
Finance providers have come a very long way in their analysis of the sector. As one senior banker remarked to us recently there is no reason why his board should not have an exposure to the fund of hedge funds space if they are equally prepared to lend to, for example, a single corporate or the distress sector. In practice, financial institutions are now likely to have an involvement with hedge funds through a number of channels, including owning hedge funds or FOHF, acting as a prime broker or as custodian, distributing related products and advising clients. Providing leverage is an obvious extension of or complement to this knowledge.
Some of the key considerations which will apply to any finance provider’s assessment of a FOHF portfolio include:
- Concentration risk and correlation: Most banks focus on lending to diversified portfolios and therefore many do not look to leverage portfolios below a certain minimum number of managers (between 15 and 20 is a common benchmark) or within too narrow a style band. In practice, hedge fund style classifications have been one of the challenges – one manager’s trading style can often satisfy two or more conventional strategy classifications, with “multi-strategy” a potentially ubiquitous label. In practice the banks now have a more developed sense, ignoring convenient industry labelling, of where potential correlation hotspots lie and structure their investment restrictions accordingly.
- Liquidity: Understanding how long it will take the borrower to liquidate underlying positions and the realistic cash return expectation on liquidation is fundamental to the bank’s analysis. The industry trend towards longer lock-ups, as managers either impose longer lock-ups as part of their commercial terms or seek to access new sources of alpha with less liquid characteristics, can be challenging given the impact on the liquidity and valuation profile. As a result product providers may face a trade off between the potential for higher returns in the longer term from these allocations and limiting leverage at the product level.
Commercial Terms and Pricing
- Tenor: Whether or not there is a complete match between tenor of a product and tenor in underlying financing will often depend on the format adopted. For example, Constant Performance Portfolio Insurance (CPPI) and other option-based payout structures with embedded leverage will typically deliver financing to the structure at a fixed rate and by reference to a fixed notional for the life of the product. While this mitigates the risk of a credit crunch, it can tie in the financing in a way which can restrict periodic refinancing and renegotiation (and therefore the opportunity to take advantage of improved terms in the market). In addition it may not take into account improved trading performance reducing the requirement for leverage. An alternative is to develop a portfolio approach with a suite of banks offering financing at tenors less than product maturity, but where the pool is sufficiently broad to create competitive tension on pricing and deliver a sufficient secure supply on refinancing.
- Pricing more generally: Closely linked to the tenor debate, other key areas of negotiation here are advance rates and “commitment” versus “use” economics, part of the broader question for the bank of its return expectations on the financing package as a whole over the life of the financing deal.
- Legal Structuring: While there are some inherent limitations given the nature of the asset class (in particular as regards transparency and liquidity), broadly speaking the range of credit tools which are applied by banks across all of their portfolios can be made to work in a FOHF/structured product context. Structural drivers for lenders include the characterisation of transaction as trading book versus balance sheet and the relative security position which different structures will afford. Until recently, total return swap and repo structures tended to dominate the market, largely due to their simplicity (pure derivative form) and the relatively large pool of banks familiar with these formats. Public Collateralised Fund Obligations (CFOs) have been used as an additional/alternative way of delivering leveraged exposure to an allocation (allocating entity buys equity in rated SPV which is levered through tranched capital markets debt issuance). EMTN programmes have also been used as a way of tapping the debt capital markets programmes in a comparatively quick and efficient manner. More recently private CLOs (in particular with financing secured via variable funding notes) have become increasingly utilised as a means of delivering operational flexibility to product providers as banks become more familiar with the asset class and build relationships with carefully chosen product providers.
- Security and subordination: In most FOHF/structured products structures there is leverage at various levels and potentially from different finance providers in respect of the same portfolio. This implies careful consideration of priorities and subordination. Prime brokers will always be closest to the assets and therefore have first call on those assets, hence the relatively low rates for lending at this level. However as assets pass up the chain towards the end investor products, financing counterparties will want to know that they are first in line. Whether the nature of the security taken translates as full blown transfer of e.g. shares in an allocating vehicle, a security interest or even a negative pledge arrangement will depend largely on the bank’s view on enforceability and the structure of the transaction adopted.
- Operational: A detailed analysis of the operational considerations for product providers is beyond the scope of this article. In broad terms, one of the main considerations is collateral management - leverage levels can fluctuate as a function of, for example, investment performance, portfolio re-allocations and investor subscriptions/redemptions. This can result in an “ebb and flow” of collateral to support the revised arrangements which may be operationally burdensome. Flexible security packages are therefore preferred. Other likely considerations will include reporting covenants and formats, execution capabilities and product timetables and information covenants in “blow-up” scenarios (recently tested in the series of 2006 market failures).
In terms of market trends and future challenges, as the industry matures and investor sophistication on individual manager and strategy selection increases either as a stand alone view or as part of a core/satellite approach to the hedge fund sector generally, providers will be looking for financing on “narrower” portfolios. Equally, as noted above, longer lock-up strategies may test bank financing models potentially built on more liquid assumptions. An interesting area to watch will be “synthetics” and in particular whether the credit default markets can provide a means for the banks to syndicate credit risk in relation to their own exposure to what are currently relatively bespoke underlyings.
To close, 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.
The full length article, exploring in more depth the issues and challenges surrounding this topic can be found below.
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