Nature abhors a vacuum or ‘horror vacui”

By Jerry Lees – Published in HFM Weekly, December 2014

Executive chairman of Linear Investments, Jerry Lees, explains to HFMWeek the impact of Basle III and AIFMD on emerging funds

The banking crisis combined with the resulting longer-term structural changes has put increasing pressure on banks to strengthen their balance sheets and reduce risk exposure. These changes are now rapidly filtering through to the hedge fund space, the pace forced by the impending impact of Basel III in 2015, and many hedge funds are finding themselves without a home.  At the same time, costs and operational/regulatory burdens are escalating following the implementation of the AIFMD directive. Hedge funds are being squeezed from all sides.

This vacuum in the market creates a problem for many and an opportunity for those ready to fill the void.  There is growing demand for boutique prime brokers to consolidate smaller and mid-sized hedge fund businesses and deliver a more palatable product back to the global prime brokers (PB) in terms of both size and structure.  In addition, the implementation of the European AIFMD has imposed increasingly severe operational cost and capital burdens on the smaller hedge fund which are better spread across a number of smaller funds within a group solution provided by a specialist PB service structure.

Basel III minimum liquidity coverage ratio (LCR) requirements are not scheduled to take effect until 2015, but banks have already started restructuring their shorter term funding and liquidity ratios in preparation.  Capital requirements were the first part of the Basel III regulations to become active, increasing from 4.5% minimum tier 1 capital and 8% minimum total capital in 2013 to 6% and 8% respectively in 2015.

Additionally, structural changes are reducing the bank’s ability to internalise and offset the assets of one client to cover shorts within another.  Under Basel III the offset can only be counted at 50% for LCR purposes in some cases, although there has been a softening of that approach in recent weeks. This will potentially radically increase the cost of financing  to the prime broker inevitably leading to a cost increase for hedge fund clients.  This in turn will force many funds to change strategies as costs escalate undermining the profitability of long/short positions.

Prime brokers are now carefully inspecting their navels and looking at their capital requirements and what Basel III will mean for them in terms of balance sheet use. Client reviews are now frequently undertaken on the basis of how much balance sheet they use, how much leverage and short selling is required versus income and resource use. It’s not just size – although smaller hedge funds will generally generate less fees (unless they are engaged in specific strategies such as high frequency trading), whilst at the same time requiring the same if not more resources to manage them.

This is leading to large-scale reduction in exposure to hedge funds by many global prime brokers who are discretely, and sometimes not so discretely, trying to find ways of shedding unwanted clients.  We, at Linear, have had a number of hedge funds approach us in recent months with urgent requirements to find an alternative house. The Wall Street Journal reported a cull of hedge funds by large prime brokers back in August this year, Goldman Sachs Group in the US, recently announced it is scaling back significantly and a white paper published by JP Morgan confirmed that; “Structural challenges to the prime brokerage financing model are, in effect, structural challenges to the hedge fund financing model.”  Accordingly, the report goes on to say, hedge funds should expect significant changes in their relationships with prime brokers.  European prime brokers are engaged in the same process.

How and why are boutique players, such as Linear, able to fill this gap and take the place of the global players for smaller and medium sized funds?  The answer, as you might expect, is not single threaded.

The solution is a combination of the lower costs base of the boutique, which enables a business such as Linear to provide high service levels competitively without the huge operational overheads of a global bank structure.  In addition, the specialist prime broker is able to consolidate the business of many smaller clients and block up the outcome to represent significant income streams for the global prime broker whilst only giving the larger PB one counterparty to deal with.  The specialist prime broker is able to invest in IT and systems unavailable to the smaller hedge fund due to cost and scale. There are also mitigating internal offsets available to the intermediary prime broker creating room for a spread of fees between the global broker and the smaller hedge fund.  And, by consolidating services such as regulatory oversight, offshore structures, compliance, risk, IT, portfolio management systems, middle and back office and capital raising across multiple clients – the boutique prime broker delivers serious economies of scale.

This leads me to explain why an effective boutique prime broker must have a complex array of services in order to deliver value to emerging hedge funds. The burden of the new regulatory structure under AIFMD has created a massive increase in the costs and complexity of running any hedge fund and effectively creates a significant operational barrier to the success of smaller funds.  Linear are increasingly being approached by smaller funds who wish to shed the operational, back and middle office, capital raising, compliance, risk, IT and even facility costs such as office space. Linear has responded by grouping together a bundle of service elements, which include all of the above facets. This approach allows a smaller fund team to streamline their operation and focus on their investment strategy.

In effect, all of the services required to support any hedge fund are now provided as a shared cost spread across many funds and in some cases bundled in as a full service offering under the prime brokerage fees. This reduces the hedge fund’s costs, greatly simplifies their model and structure and from the point of view of any investor the fund has a third-party ensuring adherence to regulatory and operational standards. This can resolve many issues of proof of process for smaller funds as they can point to a neutral service supplier providing a high standard of control.

Finally, raising capital for the smaller fund is a very difficult, costly and time consuming task in the current environment. They are too small to be considered by the big investors for the global PB roadshows etc. Investors are massively risk averse and track record is fundamental, due diligence is extremely time consuming and finding an investor prepared to risk funds in early stage and smaller funds is like finding a needle in a haystack – not least because potential investors are secretive and cautious about advertising their presence. Once more the specialist PB is able to fill this void by providing IT, marketing budget and specialist sales resources, which can provide a common service across multiple fund clients looking for similar investors.  By grouping seeder funds this process can be made more efficient and help the fund go through various stages of feed capital and acceleration capital.

In summary, the pressures of Basle III and AIFMD combined are forcing prime brokers to shed smaller hedge funds whilst those funds operational and regulatory cost burdens are increasing greatly; A squeeze at both ends. The solution has to be through specialist firms such as Linear who can bring together effective operational solutions for hedge funds and deliver a client product to the global prime brokers that meets their needs for return on capital deployed. The specialist PB client, by grouping multiple funds into one, is effectively large enough and produces sufficient income to warrant the support cost, capital deployed to justify the business to the global prime brokers.

BIO: Jerry Lees

Executive chairman of Linear Investments – Prime brokerage, execution and Hedge platform services including FCA incubation and Capital Introduction.  Jerry Lees founded the electronic trading and prime broking business of CA Cheuvreux, and was the original founder of businesses at the beginning of the global cross border DMA industry, involved in FIX from the outset and founder of multiple successful technology and financial businesses.