Alpha - September 2007 - (Page 28)

Barry Bausano vocal liquidity injections from the Federal Reserve and the European Central Bank to make sure that the liquidity issues we’re facing do not become solvency issues. There’s a big distinction between the two: A liquidity problem occurs when you are short on cash but have plenty of assets; solvency issues occur when liabilities exceed assets. Some large hedge funds reported that their prime brokers began tightening credit and margin requirements in advance of the subprime meltdown. Has that been the case across the board? tion and concentration of assets and a manager’s history. How has the prime brokerage industry changed over the past few years? That sentiment reflects only a few, low-cost providers of capital to the market — some of whom have lost money in their credit businesses as a result of recent market conditions. Deutsche Bank had the foresight to be negative on the subprime market and, as a result, many of our clients, who are able to access the whole bank through our integrated sales force, were ahead of the curve in that sector. BRIAN CORNELL, Some prime brokers use MANAGING DIRECTOR, their willingness to offer hedge MESIROW ADVANCED STRATEGIES funds cheap money as their main selling point, as they do not have a large balance sheet. These ﬁrms tend to suffer in turbulent markets because, while they may offer moreattractive margins, they do not have adequate protection for themselves. It’s a cycle that you see in the credit world all the time. “The most savvy hedge funds have moved away from their dependence on prime brokers for ﬁnancing.” Several factors have caused prime brokerage to evolve from a collateral-based, agency-lending business to a riskbased, portfolio-finance business. The advent of derivatives allows hedge funds to be leveraged outside the constraints of Regulation T — the Federal Reserve Board regulation governing customer cash accounts and the amount of credit that brokerage ﬁrms and dealers can extend customers for the purchase of securities. There has been increasing variety in the products prime brokers manage in their portfolios; derivatives now enable hedge funds to borrow against even esoteric assets. And prime brokers have become broad financiers for hedge funds, helping manage the liability side of their portfolios. What will drive continued growth among hedge funds? We’re seeing three macro trends in the industry: internationalization; a shift toward multistrategy and multiproduct managers; and oligarchy, where large funds are becoming even larger. Which of these trends will be most affected by the recent market troubles? Did the summer’s market volatility cause Deutsche Bank to rein in lending to hedge funds? Just the opposite. We’ve experienced growth in revenues, number of clients and market share this year, and the momentum has not subsided in recent months. The current market highlights the advantages of having a global, double-A-rated bank as a counterparty. What is the key to maintaining lending terms during periods of market stress? The trends toward multistrategy and oligarchy. The advantages of large, multistrategy ﬁrms are magniﬁed in troubled markets because threats are diminished by the diversity of the risks and streams of revenues in such funds. Big institutional investors watching the market the past two months would have seen that the performances of multistrategy managers invested in troubled areas were far less volatile than those of single-strategy managers in the same areas. The trend toward oligarchy is also supported by market stress. The firms involved in problem markets that simply continued along with their processes were the firms with industrial strength, institutional-grade infrastructure and risk management — the biggest firms that see the largest institutional capital ﬂows. How will hedge funds fare following major losses at such firms as Bear, Stearns & Co., Goldman, Sachs & Co. and Sowood? A good risk management philosophy and process. Like regulators, we worry about the possibility of idiosyncratic events and prepare for such occurrences by clearly and carefully setting the rules we use to deﬁne margins. How do prime brokers factor potential market problems into lending agreements? Lending agreements highlight events that would change the terms of the relationship. Several criteria help define the kinds of margin required to support a given strategy, such as the strategy employed by a hedge fund, investments the manager intends to make, the quality, condi28 • INSTITUTIONAL INVESTOR’S ALPHA • SEPTEMBER 2007 The hedge fund industry will be ﬁne. There’s an ongoing, secular inflow of capital into hedge funds as institutions search for returns outside of traditional asset markets. If pension funds all achieved a 10 percent allocation to hedge funds, industry assets would more than double. Hedge funds survived difficult periods in 1994 and 1998, and assets actually grew in both those years. Similarly, I think assets under management at hedge funds will be bigger in 2007 than 2006, and we’re going to see capital move between different strategies and managers. When you’re playing an aggressive game, there are winners and losers — you see that in every field, not just hedge funds.

Table of Contents Feed for the Digital Edition of Alpha - September 2007

Contents Letter from the Editor Longs & Shorts Pension Corner: Keeping the Faith The Good Guys: Going Public Interview: Barry Bausano - A Delicate Balance Cover Story: Cruel, Cruel Summer Profile: Phil Cooper - Alternative Flight Plan Strategies: Marshall Wace - TOPS in Its Field Profile: Fortis Investments - Banking on Alternatives Research Center: Top Equity Trading Firms Alpha Bytes: Desktop Duel Unhedged: Commentary - The Taxman Cometh

Alpha - September 2007

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