As if investment banks weren’t in enough trouble following the much publicised write offs on US sub prime debt, they are coming under increased scrutiny from their prime brokerage clients. Hedge funds are demanding tighter contractual requirements on the utilisation of their assets.
According to Neill Ebers, chief operating officer of Lionhart, which runs $800m (€527m) in its global multi strategy arbitrage fund, there has always been concern about how assets and cash are held by prime brokers, but investors are asking more questions after the events of last year.
Jesper Bang, head of prime brokerage at Dresdner Kleinwort, agrees: “Hedge fund managers are under a lot of pressure from investors. They’ve seen a lot of investment banks having difficulties and they know that the traditional prime brokers are large
investment banks.”
Mr Ebers explains: “For the most part, cash with prime brokers is not protected by Client Money Protection, the argument being that the investment banks are extending finance and leverage to you, so they want to access as much of your assets and the cash as possible.”
A contractual clause also generally permits prime brokers to appropriate clients’ assets – a process known as rehypothecation. “The reason that’s built in is that when you are
borrowing securities, employing leverage, borrowing cash, rather than posting cash to collateralise, they look to utilise collateral held in the form of your long assets.”
There are two areas of concern, according to Mr Ebers. One is that blanket rehypothecation rights allow prime brokers to use a hedge fund’s assets even when it is not borrowing or running leverage in that portfolio.
“Most multi strategy arbitrage hedge funds are very conscious of the prime broker’s right to rehypothecation,” he says, “as it is common for multi-strategy arbitrage funds to leverage assets, and engage in securities lending activities, among other borrowings.”
However, he adds that “a number of hedge funds are not actually employing leverage or securing borrowing, and prime brokers’ claiming or having rights to rehypothecate their assets is being hotly debated.”
According to Steven Cowcher, head of prime brokerage sales, Dresdner Kleinwort has had numerous enquiries from hedge funds seeking an alternative to the big investment banks.
“There is genuine concern about prime brokers having the ability to rehypothecate assets out of hedge fund clients’ accounts,” he says. “It is historically the norm for prime brokers to have almost no restrictions, so they can freely move assets in and out of clients’ accounts to generate revenue for themselves.”
The second worry, according to Mr Ebers, is the potential for prime brokers to replace assets with a cash equivalent: “For example, if you buy Volkswagen or BMW as a long or as a pairs play and someone rehypothecates your assets and has a legal right of giving you a cash equivalent substitute, your exposure and risk has suddenly changed.”
This “dangerous” possibility is, he says, unlikely in practice but often built into the legal detail of prime brokerage contracts.
Leading investment banks contacted by FT Mandate proved reluctant or unavailable to comment. However, Frank Magani, managing director of US “mini-prime” firm SIP Prime, which acts as intermediary between hedge funds and clearing houses, says his clients are not worried.
“In terms of lending out securities, the clearing firm would still do it,” he says, “but we are very selective in who we choose as a partner. We have not seen any concern among our client base with respect to the firms we are dealing with on a daily basis.”
While acknowledging that these firms are “basically allowed to do whatever they want” with the hedge fund assets, Mr Magani stresses that there are “a lot of safety controls in place” in the US: “All the big investment houses have coverage.” He adds that, in theory, agreements could be changed to restrict the lending out of securities, but describes such a move as “quite unusual”.
This is in contrast to the views of UK-based Lionhart, as well as the trend anticipated by Dresdner Kleinwort. According to Mr Ebers, while prime brokers are fighting to retain rehypothecation rights to keep up profit margins in times when borrowing is expensive, a number of hedge funds have been pushing for limits.
These might restrict rehypothecation in line with borrowings, or require that a client be informed before assets are rehypothecated. Mr Ebers adds: “At Lionhart, we would never enter into contracts with a prime broker that gives them a carte blanche right to
rehypothecate our assets.”
According to Mr Bang, it is easier for Dresdner, as a commercial bank with a large balance sheet, than it would be for an investment bank to introduce arrangements to reassure hedge funds – although clients can expect to pay more for prime brokerage
services if they do limit rehypothecation rights.
