Leverage — that elixir of heady returns and headaches of losses — isn’t what it used to be. Hedge funds don’t want it, and banks don’t want to extend it. At least, that’s been the conventional wisdom for the past several years.
Taxpayer-funded bailouts of big banks have given way to a slightly more draconian regulatory regime. Under the new Basel III international bank regulatory requirements, which start to go into effect at the end of the year, banks are being forced to set aside more capital to cover potential losses. As a result, some prime brokerage units have already begun squeezing clients, demanding extra collateral and higher rates for products deemed risky by regulators.
Until the meltdown of 2008, banks never felt such constraints in their prime brokerage business. As one former prime broker explains, “There was no internal cost of capital calculation.” He adds that banks were charging as little as 20 basis points to lend to hedge funds, which made no sense on a risk-adjusted basis.
These numbers helped fuel the hypercompetition in prime brokerage, which historically had been dominated by three names: Goldman Sachs, Morgan Stanley and Bear Stearns (now part of J.P. Morgan). Everybody wanted in because it was such a lucrative business regardless of the rates being charged. Just being a custodian for assets — another way of avoiding capital commitment — is attractive on its own. Prime brokers make money every day of the year. And if a fund blows up, no problem. The bank still owns its assets.
Some hedge fund execs believe that regulatory reform is just an excuse that dealers are using to try to raise prices. But with trading volumes still muted, competition for business is keeping the lid on that effort. Many hedge funds say they aren’t feeling the pinch. Smaller players that don’t have to meet the capital requirements — firms like Jefferies, for example — are trying to muscle in.
There may be other ways around the heftier capital charges. Some banks lend to hedge funds indirectly through their managed-account or bank platforms. Since the money isn’t being lent directly to outside clients, in theory no capital is being extended. Deutsche Bank, for example, has a select platform that houses such funds as BlackRock, Jana Partners, Paulson & Co. and Third Point.
The biggest hedge funds have become such huge institutions that they have found other ways around the prime brokers. A senior executive at a $20 billion-plus hedge fund says it has started going directly to European banks, instead of through prime brokerages, for loans. In the past, it would have gone to, say, Goldman, which would turn around and finance the deal with a bank in Europe. “If you have the staff, good enough credit and a good track record, you can do it,” says another hedge fund exec.
So, is leverage on the rise after all? The new Securities and Exchange Commission reporting requirements for hedge funds have caused a stir because some of the biggest funds are showing regulatory assets under management that are many multiples of their hedge fund assets. In some cases, it looks like a ton of leverage is being added. But it’s more complicated than that. Millennium Management, for example, reported $119 billion RAUM versus $14.2 billion in hedge fund assets according to Institutional Investor’s Hedge Fund 100. Citadel’s $113 billion in RAUM also dwarfs its $11 billion in hedge funds.
Stripping out how much of that is net leverage may be impossible. Hedge funds will have to report such numbers privately to the Federal Reserve Board later this year, but the public won’t get a glimpse of them. Still, the numbers are revealing. Citadel, which cut leverage in half during the 2008 crisis, when it lost more than 50 percent, hasn’t just larded on debt to hit its high-water mark. It has a market-making operation that gooses up the numbers. The RAUM number doesn’t net out exposures, so a fund with several cross-collateralized long-short books like those run by market-neutral strategies such as Millennium’s can look huge. But for the Fed, which is looking at systemic risk, these big numbers are telling. In the event of a crisis, there’s not a ton of capital behind these firms’ gross positions.
In contrast, quant leverage looks modest these days. D.E. Shaw, for example, has RAUM of $49 billion versus $17 billion in hedge fund assets. Renaissance Capital reported $49.3 billion in RAUM versus $20 billion in hedge fund assets. Even if all of that accounted for leverage, the two would be between only two and three times levered. That’s much lower than the average leverage before the quant meltdown of 2007. Interestingly, despite the lower leverage, both firms were strong performers last year. In volatile times, caution can be its own reward.