Hedge funds will need to reassess processes amidst Basel III changes

Hedge funds need to think quickly about the mechanisms by which they obtain financing amid concerns that Basel III will likely lead to prime brokers reigning in their financing operations due to incoming capital requirements.

Basel III is going to bring about radical changes at prime brokers. Banks are going to be forced to hold high quality liquid assets (HQLA) that are sufficient to withstand a 30 day market stress event. Furthermore, the rules seek to reduce banks’ reliance on short-term funding for fear of liquidity mismatches through the Net Stable Funding Ratio (NSFR). Hedge fund cash deposited at these banks is prone to flee in times of volatility and regulators are demanding banks hold more capital to safeguard against this risk. This has prompted a number of banks to terminate relationships with small or unprofitable hedge funds.

“The implications of Basel III should not be underestimated by hedge fund managers. Some prime brokers may view smaller managers or firms which have not grown Assets under Management (AuM) sufficiently as a cost burden because of the capital requirements under Basel III. As such, these hedge funds could face having their prime brokerage relationships terminated,” said Peter Coates, chief executive officer at Omni Partners, a London-based investment manager.

Should prime brokers scale back financing, hedge funds could see a substantial drop in returns. Furthermore, being exited by a prime broker could result in redemptions as a number of institutional clients might not want to remain invested in a manager where the prime broker has lost confidence. It could also be a struggle for those managers to get on-boarded by a reputable alternative provider in good time. “This is an issue that is at the forefront of hedge fund managers’ minds,” said Coates.

Credit Suisse, Bank of America Merrill Lynch and Goldman Sachs have all scaled back their prime brokerage offerings to smaller clients. The strategic shrinkage at Deutsche Bank could result in a review of some prime brokerage clients too. Some banks have even increased prime brokerage fees to unsustainable levels for some managers as a means to bring about a change in provider.

Some hedge funds are now electing to have single prime brokerage exposure, instead of the multi-prime model that was adopted following the demise of Lehman Brothers as a way by which firms could spread their counterparty risk.

Some investors have expressed disappointment at this development. “Hedge funds must be transparent about the changing nature of prime brokerage, and many investors will recognise the predicament they are in. It is all about economics and value to the prime broker, and investors will be sympathetic provided that managers explain why they have reduced the number of primes that they are using,” commented Coates.

As such, hedge funds might need to explore alternative financing mechanisms.  Coates highlighted that a number of financial institutions were not ensnared by Basel III and were increasingly concerned about their Return on Equity. Such institutions might one day build up their internal infrastructure to provide financing to hedge funds.

Some large multi-manager hedge funds are building treasury functions and this could lead to them providing financing to others. Given the recent lacklustre returns, providing financing could become a consistent revenue generator. Prime brokers could even act as facilitators for this financing, it has been suggested.

Another alternative could be private equity. A number of private equity managers are sitting on record levels of dry powder and many of their end-clients are getting impatient at the lack of viable deal-making activity. The strong equity market is forcing other private equity firms to pay over and above what they should be spending on deals. Some may view lending to hedge funds as a useful revenue generator too.  Building the infrastructure and technology to facilitate financing for hedge funds is not straightforward though, a point made by prime brokers.