More Credit, Lower 'Haircut' Requirements Flood Hedge Fund Market

Of the 36 hedge funds polled by Greenwich Associates, nearly one-third have increased their use of leverage over the past 12months. Additionally, 25% of the respondents say their prime brokers – firms that provide financing, custody and other back-office services to a hedge fund – are extending more credit now thanthey were six months ago, and 20% said that their prime brokers haddecreased their haircut requirements during the same period.

“None of these developments – a flood of pension capital, increasingleverage, declining haircut requirements or easier credit – would, onits own, be a cause for immediate concern,” explained GreenwichAssociates consultant Peter D’Amario. “In aggregate, however, thesetrends bear serious consideration on the part of hedge fund investors,not only as possible indicators of an ‘overheated’ market, but also aspotential harbingers of intervention by regulators in the United Statesand Europe.”

Greenwich traces the root of these trends in large part to competition among investment banks for prime brokerage business, especially as pension funds have been searching for more alternative investment vehicles in recent years, spurring the growth of the hedge fund industry.   In particular Greenwich notes a move toward more prime brokerage activity in the United States and Europe due to a decline in the equities and mergers & acquisitions businesses in recent years. Thus, with more capital flooding into the market, prime brokers are extendingmore credit, reducing haircut requirements, and wielding otherservice offerings to attract and win business.

“Without a doubt, the ability of hedge fund managers flush with capital – including pension capital – to shop from multiple prime brokers’ offerings is contributing to the overall growth of the hedge fund industry,” said Greenwich Associates consultant Tim Sangston. “The question is whether the industry is growing too fast. Has it become too easy to set up a hedge fund? Has it become too easy to get capital? Has it become too easy to leverage?”

In fact, Greenwich forecasts greater regulatory scrutiny will befall hedge funds in coming months, culminating in new regulations in the bothUnited States and the United Kingdom. For plan sponsors concerned about the impact on their hedge fund investments, Greenwich suggests staying ahead of any new regulation by taking careful measure ofthe risk-management procedures, disclosure policies, leverage levels,and capital introduction practices of funds under consideration forinvestment.

Greenwich surveyed hedge funds located in the Americas, the United Kingdom, and Europe and asked them about their investment strategies, capital raising, prime brokerage relationships, credit, leverage levels, and views on industry regulation.