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Asset Management Intelligence - November 2015 - The Good Client

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With all the regulatory change that has impacted the banking industry, it’s become increasingly difficult for hedge funds and alternative managers to fund their portfolios and borrow securities.  Everyone has heard of the alphabet soup of regulations: BASEL III, Supplementary Leverage Ratio (“SLR”), Liquidity Coverage Ratio (“LCR”), High Quality Liquid Assets (“HQLA”) ….  What does it mean?  Unfortunately, it means that balance sheet is becoming more of a scarce resource.  Economics 101 tells us that as a resource becomes harder to come by, it becomes more expensive.  What is a manager to do? 

All hope is not lost.  Liquid, balanced portfolios are still in demand at prime brokers.  Managers that have broad-based relationships with their providers are very much in demand.  Return on assets (“ROA”) matters.  Balance sheet discipline matters.  Tenor of your trades matters.  Clients who understand the notion of a “good client” will always have a home.

So what matters to a prime broker?  First, the asset being funded or borrowed is assessed.   Treasuries and equities are the most desirable assets.  Prime brokers have clients looking to borrow those securities.  Funding markets for those assets are liquid and deep.  Regulators are driving the funding of those assets to centrally cleared facilities.  Believe it or not, this could be one very good outcome from all the regulatory change.  Less liquid assets will be more difficult to finance.  Convertible bonds and corporate credit have less demand to short and finance.  Funding of those assets consumes more balance sheet.  Understanding the risk-weighted asset (“RWA”) levels of illiquid assets (and the RWAs on your funding partner’s balance sheet) is critical to ensure that consistent funding is available for those assets.

Second, a prime broker likes the self-funding portion of a portfolio.  Portfolios where short balances are greater than or equal to debit balances can self-fund.  The balance sheet footprint of this portion of a book is manageable.  Basel III rules are generally kind to well-balanced books.  Directional portfolios that utilize leverage or securities lending will use more balance sheet.  Managers will need to have an open dialogue with their providers about the cost to fund that portion of the book and ways to manage the balance sheet impact.   

Third, term matters.  Overnight funding is the most desirable and the most readily available from a prime broker.  Overnight funding works for most portfolio managers.  Know the liquidity of your asset.  If you can unwind your portfolio in a few trading days, term funding is expensive and might not be necessary to maintain your positions through all market environments.  Likewise, books of liquid equities in developed markets rarely need term financing. LCR considerations increase when a manager requires term financing of 30 days or more. Banks need to match fund their books on longer duration trades. The quality of the asset will be a significant consideration in funding those assets. Clearly, long duration funding of illiquid assets can be expensive. A manager will need to have a firm grasp of the return on investment (“ROI”) of adding financing to a longer duration trade.

Last, and maybe most importantly, banks will look to the overall ROA of a relationship as they allocate balance sheet.  Shareholders are demanding increased ROA and return on equity (“ROE”) from their banks.  Regulators ask questions about terms and pricing of funding.  Disciplined product managers and sales people know their clients ROA to the basis point.  A manager needs to be sensitive to their ROA with their banks.  Several tools are available from service providers to help a manager understand their ROA.  A phone call to your coverage people will likely get you the answer as well.

A fund manager needs to understand what they need from the banking universe and who is most adept at servicing those needs.  Not all managers are the right fit for all providers.  Not all banks are the right fit for all managers.  Choose your providers with the same diligence that you use to select securities for your portfolio.  Be important to a few institutions.  Ensure that you have access to all the resources necessary to manage your fund and your business.  Have an open dialogue with your providers about your needs and their ability to service you.  Banks want to work with their good clients to ensure healthy, long-term relationships.  Know what it means to be the “good client.”


Asset Management Intelligence - November 2015

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