Key Takeaways
- • Bank lending to hedge funds and hedge fund-linked products has grown markedly over the past decade, with a wide range of credit providers now competing for exposure, according to a product provider's review by Man Investments' Structuring Unit.
- • Leverage spreads for four times leverage on a diversified fund-of-hedge-funds portfolio have probably fallen by about a third over the last five years as demand for financing outstripped supply.
- • Lenders cite HFRI Fund of Funds index annualised volatility of 5.9% for 1997-2006, versus 15.2% for the S&P 500 and 13.9% for the FTSE 100, as support for the view that lending to diversified portfolios is less risky than initially assumed.
- • Minimum utilisation fee structures are replacing traditional commitment and structuring fees, but carry make-whole risk if utilisation falls in later years.
- • Managers are advised to balance the number of leverage providers, weighting selection toward experienced teams and provider continuity rather than pricing alone.
Summary
The Hedge Fund Journal published an article by Alistair Bool, Laurence Fitzpatrick and Andy Knox of Man Investments' Structuring Unit, written ten years after Man Investments entered its first significant external leverage transactions. The piece focuses on leverage at the fund-of-hedge-funds (FOHF) and structured product level, where financing is used primarily to increase allocatable capital or provide liquidity facilities, generally at less than 25% loan-to-value, rather than on prime brokerage or strategy-level margin.
According to the authors, the market for lending to hedge funds has changed dramatically over the last five years, with a significant increase in participants. Drivers include reduced traditional investment banking opportunities, banks leveraging knowledge gained from their FOHF, prime brokerage, custody and note issuance businesses, and hedge fund providers consolidating to fewer, more strategic lenders. Lenders found diversified FOHF lending more profitable and less risky than expected, citing HFRI Fund of Funds annualised volatility of 5.9% for 1997 to 2006 against 15.2% for the S&P 500 and 13.9% for the FTSE 100. The authors warn that aggressive terms from inexperienced entrants may change the currently low exit rate.
Leverage economics have shifted from supply-constrained conditions in 2001 to demand-constrained conditions today. Spreads have fallen, and providers now seek non-price concessions such as less rigid investment guidelines, reduced reporting and operationally lighter structures. Lenders also seek guaranteed income through upfront fees, commitment fees or minimum utilisation arrangements, which carry downside risk if utilisation falls and a make-whole payment becomes due. Longer tenors are increasingly locked in, though securing them is complicated by termination costs and the need for investment guidelines that remain workable over the deal's life.
The authors note that conflicts between investment guidelines and manager alpha-seeking, such as moves into weather derivatives, mean guidelines are often renegotiated. They suggest basing guidelines on manager diversification and volatility rather than style limits. They also advise managers to maintain a target number of leverage providers, selected on qualitative grounds such as team experience, continuity and senior management access, and to hold contingency plans in case facilities are terminated at short notice.
According to the authors, the market for lending to hedge funds has changed dramatically over the last five years, with a significant increase in participants. Drivers include reduced traditional investment banking opportunities, banks leveraging knowledge gained from their FOHF, prime brokerage, custody and note issuance businesses, and hedge fund providers consolidating to fewer, more strategic lenders. Lenders found diversified FOHF lending more profitable and less risky than expected, citing HFRI Fund of Funds annualised volatility of 5.9% for 1997 to 2006 against 15.2% for the S&P 500 and 13.9% for the FTSE 100. The authors warn that aggressive terms from inexperienced entrants may change the currently low exit rate.
Leverage economics have shifted from supply-constrained conditions in 2001 to demand-constrained conditions today. Spreads have fallen, and providers now seek non-price concessions such as less rigid investment guidelines, reduced reporting and operationally lighter structures. Lenders also seek guaranteed income through upfront fees, commitment fees or minimum utilisation arrangements, which carry downside risk if utilisation falls and a make-whole payment becomes due. Longer tenors are increasingly locked in, though securing them is complicated by termination costs and the need for investment guidelines that remain workable over the deal's life.
The authors note that conflicts between investment guidelines and manager alpha-seeking, such as moves into weather derivatives, mean guidelines are often renegotiated. They suggest basing guidelines on manager diversification and volatility rather than style limits. They also advise managers to maintain a target number of leverage providers, selected on qualitative grounds such as team experience, continuity and senior management access, and to hold contingency plans in case facilities are terminated at short notice.
Go deeper than the headline
Research every firm in this story, track the ones that matter and get the daily briefing — free for 7 days.