COO Magazine, Spring 2012

COO COO | peer group network | www.cooconnect.com | issue no. 2 | spring 2012

Deutsche Bank Global Prime Finance

Voted No. 1 Global Prime Broker 4 Years Running Global Custodian Prime Brokerage Survey 2011, 2010, 2009, 2008

This advertisement has been approved and/or communicated by Deutsche Bank AG London. Securities and investment banking activities in the United States are performed by Deutsche Bank Securities Inc., member NYSE, FINRA and SIPC, and its broker-dealer affiliates. Copyright Š 2011 Deutsche Bank AG.

Partnering with you to reach new heights We partner closely with our clients to bring integrated prime brokerage services, securities lending and synthetic equity solutions to the global hedge fund industry.

Client service is the foundation of our model – providing global access, seamless coverage and multi-asset financing solutions. The Global Prime Finance platform empowers you to explore new markets.

Clients can expect more with Deutsche Bank. www.db.com

Cont e n tS COO EDITORIAL 6

Founder’s letter COOConnect founder Dominic Hobson ponders the shadow banking threat.

12

Editor’s letter COO editor Charles Gubert re-makes the case for funds of funds.

COO INTERVIEW 80

COO PERSON 96

COO COLUMNS 84

What investors want from Form PF Pierre Emmanuel Crama of Signet discusses the upside of Form PF.

116 The view from the ivory tower

Kevin Mirabile of Fordham explores performance fees in the era of relative returns.

COO COVER STORY 16

How they fund what funds you How prime brokers fund themselves governs their ability to fund their clients.

25

COO PLUS: Measure your financing costs Find out what you are paying your primes, then re-negotiate, then monitor.

The more he practises the luckier he gets Jerry Harworth on how 36 South profits from Black Swans.

Frank Meyer A legendary hedge fund investor reflects on his fifty year career.

COO INVESTOR 48

Brain not brawn Liongate partner Ben Funk talks quantitative research, qualitative risk management and star-gazing.

COO Q&A 60

Managed accounts for start-ups Patric de Gentile Williams of FRM Capital Advisors says managed accounts are not just for big funds.

64

Cantor Fitzgerald: prime broker Noel Kimmel of Cantor Fitzgerald explains what his firm can do for small to mid-sized hedge funds.

COO FEATURES

COO SPONSORS

68

A big cold country with a small hot market The topology of the Canadian hedge fund industry and infrastructure.

9

Fast, mobile, secure Ambitious prime BNP Paribas unveils its client reporting app.

88

How to be a mammal among dinosaurs Why some emerging managers are getting capital and others are not.

46

Why it makes sense for hedge funds to collect class action pay-outs Class action claim specialist Battea explains how to collect, effortlessly.

58

COOConnect roundtable CME Clearing Europe, Eurex Clearing, ICE Clear Europe, Credit Suisse, LCH. Clearnet’s SwapClear and the Financial Services Knowledge Transfer Network with COOConnect host a seminar on swap clearing.

COO ANALYSIS 106 Puberty blues The difficult coming of age of the Asian hedge fund industry.

4

COO

“Ever notice our current brokers always say ‘no’... until another broker says ‘yes’?”

Citi® Prime Finance: the right answer for hedge funds.

Relationships are easy, until you ask for something hard. Something that requires effort, ingenuity or risk. But, when you stop and think about it, isn’t that what the hedge fund business is all about?

So where will your fund turn for answers? At Citi Prime Finance, we’re aggressively investing in talent, resources and technology to anticipate the changing needs of hedge funds. Try us — first.

Find out more at primefinance.citi.com.

>> Global Prime Brokerage Execution to Custody Fund Administration Advisory Services Futures and Options Execution ETD and OTC Clearing

© 2012 Citibank, N.A. All rights reserved. Citi and Citi and Arc Design are registered service marks of Citigroup Inc.

Founder’s Letter

F

und managers are understandably reluctant to believe that they are bankers in disguise. They do not take deposits, or benefit from deposit insurance, or have access to central bank money when assets turn into liabilities.

The average hedge fund operates with a leverage ratio a tenth or less of the average bank and, far from funding long positions at the short end, works hard to hedge its risks. Nor are hedge funds, as the shadow banking epithet implies, outside the ambit of the regulators.

Indeed, the torrent of direct and indirect regulation now washing through the hedge fund industry means there is scarcely time to manage money between meetings with the lawyers, consultants and vendors that make up the burgeoning compliance industry.

6

COO

Such arguments are increasingly forlorn. Regulators concluded years ago that the interactions of prime brokers and their hedge fund clients posed a systemic risk. The events of 2007-08 persuaded them that the withdrawal by hedge fund managers of cash and securities held at call in prime brokerage accounts was every bit as worrying as any other kind of run on the banking system, from queues outside retail branches to the effective closure of the inter-bank money market. Customer withdrawals from prime brokers, reasoned the regulators, were at least as important as the withdrawal of counterparties from the repo market in precipitating the failures of Bear Stearns and Lehman Brothers, and the near-failures of Morgan Stanley and Goldman Sachs.

Everybody wants more from the market.

Our innovations make it happen.

Financial institutions, corporations and investors are under pressure to find new opportunities to grow their business and hedge their risk.

Success for them means making the right call in an environment they can trust.

One that’s built for speed and adaptation.

And one that balances innovation with safety.

For more than 10 years, Eurex Group has been turning ideas into opportunities in the fastest, most challenging market conditions.

By trading and clearing a growing multiasset product range.

Through benchmark technology and risk management.

Across Europe, in the U.S. and through partners around the world.

In financial and commodity derivatives, bonds, repo and post-trade services, Eurex Group is helping to shape an environment where decisions can be made quickly, reliably and with the assurance of integrity.

So everyone can get more from the market.

Find out more at www.eurexgroup.com

Eurex Group includes Eurex Exchange, the International Securities Exchange (ISE), European Energy Exchange (EEX), Eurex Clearing, Eurex Bonds and Eurex Repo.

Eurex Group is part of Deutsche BĂśrse Group.

Founder’s Letter COO Founding Partner Dominic Hobson dominic.hobson@cooconnect.com +44 (0) 208 378 9086 Editor Charles Gubert charles.gubert@cooconnect.com +44 (0) 772 581 1957 Content and Relationship Manager Anita Craw anita.craw@cooconnect.com +44 (0) 755 730 1812 Director of Sales James Blanche james.blanche@cooconnect.com +44 (0) 776 927 7927 Production Rafael Zinurov rafael.zinurov@cooconnect.com +44 (0) 844 484 3624 Timur Urmanov timur.urmanov@cooconnect.com +44 (0) 844 484 3624 Subscriptions and Reprints Bekzod Mirahmedov bekzod.mirahmedov@cooconnect.com +44 (0) 207 148 4285 COO, a publication of COOConnect, the peer group network for alternative fund managers and their investors, is published four times a year. Subscription is free to authenticated fund managers and investors. The annual subscription price is £75. The entire content is copyrighted.

ISSN 2049-2510 COO 7 Kyrle Road London SW11 6BD United Kingdom Tel.: +44 (0) 844 774 4228 www.cooconnect.com

8

COO

It has taken the failure of MF Global to coax the regulators into advancing some ideas about what to do about the fact that prime brokers use the cash and securities of their clients to finance their own risk-taking activities, and those of their hedge fund clients. If they do not want to put an end to margin lending, they do want to make it difficult for broker-dealers to use client assets to fund their own business. They want to break the long chains of intermediaries built by prime brokers and hedge fund managers that exchange cash and securities through the repo and reverse repo markets. If their initial ideas are implemented, not every counterparty will be free to accept whatever collateral they choose, or set the haircuts applied to the collateral they are allowed to accept, and every securities financing trade will be reported to a giant data utility akin to the DTCC swap repository.

For the hedge fund industry, these efforts to reduce the role of re-hypothecation through a mix of disclosure, collateral constraints and heftier haircuts coincide in a particularly unfortunate way with the heavier liquidity and capital ratios, counterparty exposure limits and less adventurous maturity profiles now being imposed on the investment banking industry, especially through Basel III and Dodd Frank (notably Section 165 and the Volcker Rule). The rising cost of funding

Fast, mobile, secure: The new PB app from BNP Paribas Prime Brokerage

For further information on BNP Paribas PB App for iPad contact Michael Zimberg by telephone on +1 212 471 6443 or by email at michael.zimberg@us.bnpparibas.com

COO

9

Sponsored Section

In the markets of today, being able to access prime brokerage account information 24/7 is an absolute necessity for hedge funds. It is precisely for this reason that BNP Paribas Prime Brokerage launched a PB App for the iPad in February of 2012.

“Mobile platforms will continue to proliferate and clients will demand additional access to their data in the mobile space,” says John Bruno, global head of prime brokerage technology at BNP Paribas in New York. “The iPad is the ideal mobile platform for Prime Brokerage data, as phones do not have enough screen real estate to see everything.” He adds that “several of our clients were happy to have an extra excuse to buy iPads.”

The app provides clients with access to predetermined reports based on portfolio holdings and historical account activity by existing institutional clients. “It offers hedge funds information on corporate actions, custody lookup, OMS, real-time P&L, reports and wires. We have an industry leading layout and design,”

adds Bruno. “We went with a native Apple application to give clients the best possible experience. Our team developed and designed several other widely used and praised mobile applications.”

While some industry participants have expressed reservations about the security of these apps, BNP Paribas has developed its version in accordance with industry best practices for data security. It has also had the service reviewed and approved by a third-party security firm. Furthermore, no data is stored on the users’ iPads and all data transmissions make use of an industry standard secure sockets layer (SSL).

Although BNP Paribas is not the first prime broker to unveil an app for its hedge fund clients, it is the first to develop realtime functionalities that enable clients to bypass frustrating data delays. “Clients have commented that getting the same information on their laptops would take 10 to 15 minutes to access, but with the iPad app they see everything they need in a minute or less,” explains Bruno.

The positive feedback has encouraged BNP Paribas to expand the offering. “We are continuing to build out our iPad application, including adding stock loan locate ability, risk management tools such as Value at Risk (VaR), stresses and Greeks, options monitoring and portfolio accounting queries,” says Michael Zimberg, director at BNP Paribas Prime Brokerage. “We are also planning an application for managers and investors based on our capital introduction activities. As an innovative institution, we gauge our clients’ needs and develop tools that are useful to them.”

Founder’s Letter a bank balance sheet is already putting prime brokers under pressure to be self-funding, particularly if they are to avoid passing the rising cost of internal funding on to their clients. That argues not for a reduction in re-hypothecation, but an increase. Already there is plenty of evidence that certain prime brokers are restricting the investment strategies they are prepared to support to those invested in assets they can finance conveniently in the repo or swap markets without taking them on to their own balance sheet or paying an excessive haircut.

These are the forces which are— paradoxically, in a period of sub-zero real rates of interest, quantitative easing and bloated central bank balance sheets— pushing up the price of prime brokerage.

So far hedge funds have compromised, spreading their business among a larger group of prime brokers, withdrawing assets promptly if the creditworthiness of a prime broker sinks below a predetermined trigger point, shopping around for the cheapest rates on a deal-bydeal basis, shifting unencumbered assets into third party custody accounts, making greater use of tri-party arrangements, and insisting on full daily reports from their prime brokers on which of their assets is currently being re-hypothecated.

Prime brokers have compromised too.

The cost of leverage rises sharply for those clients which refuse or restrict the re-hypothecation of their assets. The 10

COO

single blended rate over Libor which every hedge fund paid to borrow in the antediluvian era has given way to a more nuanced approach, in which each form of collateral attracts a particular price.

These compromises will become increasingly difficult to sustain. Hedge funds support an astonishingly large number of prime brokers, none of which is making returns of the kind their senior management and shareholders expect. The funding profile of every prime broker, as our cover story in this issue depicts, is exceptionally fragile.

Scepticism about the robustness of the asset safety and segregation services offered by prime brokers is entrenched.

Above all, the debate with the regulators is over. Unfairly or not, they have decided that the social costs of unsegregated prime brokerage (taxpayer bail-outs and recessions) outweigh the social benefits (cheaper funding and greater liquidity).

As it happens, lending securities for cash, and using that cash to buy assets or fund third parties, was never as glamorous as it seemed at the height of the boom. Even then, it was nothing but an investment bank financing its assets, in the same way as a retail bank funds its loan book with customer deposits. The difference between then and now is that the regulators have worked that out.

Dominic Hobson dominic.hobson@cooconnect.com

G L O B A L L I ST E D B E N C H M A R K S

|

OTC C L E A R I N G S O LU T I O N S

|

C M E G LO B E X

|

CME CLEARING EUROPE

Global reach.

Local presence.

CME Group provides customers across Europe, the Middle East and Africa with the opportunity to manage virtually every financial risk they face. We offer a combination of global benchmarks and a widening range of regionally-focused products and services. Supported by our growing presence in London—including CME Clearing Europe, a London-based clearing house—we provide a broad range of listed contracts and OTC clearing solutions. It all means that we’re best able to partner directly with our customers to serve their evolving needs. So no matter where you do business, we’re there to help you move confidently forward.

Learn more at cmegroup.com/emea

How the world advances

CME Group is a trademark of CME Group Inc. The Globe logo, CME, Chicago Mercantile Exchange and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago. NYMEX, New York Mercantile Exchange and ClearPort are trademarks of New York Mercantile Exchange Inc. COMEX is a trademark of Commodity Exchange Inc. Copyright © 2012 CME Group. All rights reserved.

This communication is issued by CME Marketing Europe Limited. It does not constitute a Prospectus, nor is it a recommendation to buy, sell or retain any specific investment or service.

CME Marketing Europe Limited is authorised and regulated by the Financial Services Authority in the United Kingdom.

Editor’s Letter

The case for funds of funds R

umours of the death of funds of funds are irrepressible, but exaggerated. The latest threat to these perennially embattled intermediaries comes from investment consultants, who are now directing institutional assets away from funds of funds and towards the biggest brand-name managers.

According to Preqin, just 24 per cent of investors will allocate to a fund of funds this year, sharply down on the 42.5 per cent that opted for that route as recently as 2010.

It is not unrealistic to assume that consultants now control two out of every five investment dollars going to hedge funds. The marsupial relationship of pension funds to consultants is immune to the quality of the investment advice.

This is partly because consultants shirk responsibility for the outcome, and partly because pension funds do likewise. “Consultants provide pension

12

COO

funds’ alternatives teams with pretty decent job protection,” as one fund of funds insider puts it.

The result is that nobody is responsible for the returns pension funds earn. Whatever we think of the performance of fund of funds in 200809, when their inability to control risk in the advertised manner became abjectly plain, and many funds of funds forfeited the public trust altogether by denying their investors liquidity, none of us can say that funds of funds were not ultimately answerable for the investment decisions they took. All shed assets.

Some disappeared.

But that direct experience of failure—something consultants have never felt—has proved cathartic. The best of the modern breed of fund of funds manager is a tightly run organisation. It aims to ensure that diversification is a reality and not just

Clarity for hedge fund managers.

Transparency for hedge fund clients.

Who’s helping you?

In today’s volatile markets, hedge fund managers face ever greater challenges. BNY Mellon can help by offering the transparency that leads to investor confidence.

Whether it’s adding alpha to your operations, increasing data controls or developing advanced fund administration and custody products—we focus on the needs of hedge fund managers so you can focus on the investment decisions that matter.

For more information, please contact: Europe, Middle East & Africa: Fergus McKeon +353 1 790 3512 Asia-Pacific: Aidan Houlihan +852 2840 9756 Americas: Mike McCabe +1 732 667 1378 bnymellon.com/fundadmin

Products and services are provided in various countries by subsidiaries, affiliates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorised and regulated as required within each jurisdiction. Products and services may be provided under various brand names, including BNY Mellon.

This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorised. ©2011 The Bank of New York Mellon Corporation. All rights reserved.

Editor’s Letter a label. It is willing to allocate to the newer and smaller and up-and-coming hedge funds that have always produced the exceptional returns in this industry.

It has cut its fees, and brought new discipline to operational due diligence.

Consultants, on the other hand, are doing what they always do best: moving timid and ignorant institutional clients into a small band of large, lookalike funds whose returns are highly correlated. Familiar gossip about payto-play and finders’ fees are circulating.

The chief beneficiaries are not investors but that class of hedge fund manager most determined to ape the long-only model, in which the rewards come not from performance, but from adding assets and cutting costs.

In short, consultants are glorified access vehicles to hard closed or brand-name managers—precisely the model which funds of funds tested to destruction in the run-up to the crisis which started in 2007. Given the Teflon-like reputation of the consultants, through every revolution of the financial markets cycle, it is hard to believe that even their worst decisions will do much damage to the entrenched relationships they enjoy with their institutional clients.

The best hope for a revolution in the quality of investment advice given to institutions now lies with that minority of pension funds which have broken 14

COO

with the investment consultants, and are managing their own money. Inevitably, this option is reserved for larger funds with sufficient resources to recruit and run their own investment management function. Those without the resources will have to find an alternative solution.

They should take a fresh look at funds of funds. Like investment consultancy, they were invented for investors short of time and expertise.

They incorporate research and allocation decisions as part of the package. They accept investment amounts that some single managers still find disagreeably small. They have addressed the doubling-up and correlation criticisms. True, they do still add an extra layer of fees, but it is a thinner layer than it was.

The funds of funds of old had many bad habits. They misjudged correlation and volatility risk. They relied on reading numbers rather than hard work.

The barriers to entry were too low, yet the fees remained outrageous. They chased assets instead of returns. They leveraged their funds to goose returns.

They used pro forma performance data, and were fond of meaningless jargon.

Unlike investment consultants, however, they are not too proud to learn from experience.

Charles Gubert charles.gubert@cooconnect.com

COO Cover Story

“They dial for dollars. Our guys would borrow maybe $75 billion a day, something in that neighborhood, most of it daily. It’s not like you’re dialling strangers. You’re calling up the guy who loaned you the money yesterday and going, ‘You okay with it today? What’s the rate today? Okay, great. Thanks.’ You tweak it up and down as people need money, and you tweak it up and down as you buy or sell collateral. Basically, the vast majority of it just rolls in the normal course. It’s of course insane. In the normal world it would be insane, and in this world it’s really insane.”

Paul Friedman on the how the Bear Stearns repo desk worked in 2007 Quoted in William D. Cohan, House of Cards: How Wall Street’s Gamblers Broke Capitalism, 2009

16

COO

COO Cover Story

COO

17

COO Cover Story

T

he insanity Paul Friedman described is still with us. As Table 1 shows, the repo market still accounts for a sixth of the funding of the two largest independent investment banks, and more than a quarter of the funding of the main surviving independent broker-dealer.

Even the average universal bank active in the prime brokerage business, whose access to funding from the deposits lodged with its retail or private banking arm enables its treasury department even now to take a somewhat disdainful view of the repo market, secures a tenth of its funding from exactly that source. In

fact, as Table 1 also shows, the difference between the average reliance on repo funding of the top ten prime brokerage houses at the end of last year (17.7 per cent) was not massively different from the reliance of Bear Stearns in late 2007 (25.9 per cent) or Lehman Brothers in the early months of 2008 (20 per cent). At the end of 2006, the last of the pre-crisis years, funding a fifth or more of a brokerdealer balance sheet in the overnight repo market was by no means outlandish.

Morgan Stanley then relied on repo to fund a third of its assets, and Goldman Sachs just under a quarter. Today, the

Table 1. Broker-dealers on the verge of failure versus prime brokers today Bear Stearns Lehman November 2007 Brothers May 2008

MF Global Goldman Sachs Jefferies &Co March 2011 and Morgan 2011 Stanley 2011 (average)

Universal Banks 2011 (average)

Top ten prime brokerage providers 2011 (average)

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Total $395,362m Leverage*

33.5X

Payables Short term debt *Assets/equity

18

COO

$639,432m

$40,541m

n/a

$34,971m

n/a

n/a

24.3X

26.9X

11.9X

9.9X

20.8X

14.2X

Short positions Deposits

Derivatives Long term debt

Repo Equity

Reverse repo

Other

COO Cover Story

average bank or broker-dealer with a large prime brokerage business is still raising a sixth of its funding in the repo markets.

Repo terms have of course lengthened since 2006-07, and recapitalisation of balance sheets means that reliance on the overnight or term repo markets has fallen back sharply since the crisis began. At least one prime broker has a repo book whose repo term averages six months. Most prime brokers are looking to finance equity and corporate debt at term, on grounds general collateral is the only asset class that can funded reliably overnight. In fact, as Tables 2 to 12 show, the reliance of the ten leading prime brokers on all forms of short term funding has diminished. The proportion

of the balance sheets of Goldman Sachs, Morgan Stanley and Jefferies & Company funded by long term debt and equity capital has increased from 17.1 per cent at the end of 2006 to 28.4 per cent at the end of last year. Among the seven universal banks with large prime brokerage businesses—namely, Bank of America Merrill Lynch, Barclays Capital, Citi, Credit Suisse, Deutsche Bank, J.P. Morgan and UBS—the average proportion of long term debt and equity capital on the liability side of the balance sheet has increased from 15.8 per cent at the end of 2006 to 19 per cent at the end of last year. Yet, as the fluctuations in credit default spreads for leading prime brokers over the last 12 months and

Chart 1. Five year CDS spreads for 12 months ended 30 March 2012 550 500 450 400 350 300 250 200 150 100 50 0 30 March 2011

21 May 2011

Morgan Stanley Deutsche

12 July 2011

02 September 2011

Bank of America UBS

25 October 2011

Goldman Sach Credit Suisse

16 December 2011 Citi J.P. Morgan

06 Febriary 2012

30 March 2012

Barclays Source: Bloomberg

20

COO

“Experience” is an overused buzzword.

Until there’s a default.

SwapClear is the only clearing service to have successfully handled an OTC interest rate swap default. When the worst happens, you need the best on your side. swapclear.com

We’re ready. Are you?

COO Cover Story

especially in the fourth quarter of 2011 words, investment banks remain heavily indicate (see Chart 1), counterparties reliant on using the cash, securities and remain nervous about the stability of the derivatives receivables of their customers funding of a number of investment banks. to fund their assets. This is of course The five year CDS spreads of Morgan how the entire fractional reserve banking Stanley, for example, fluctuated between industry operates. It is what makes banks 612 and 312 basis points in the month of among the most profitable of businesses, October 2011 alone. but also the most Table 2: Goldman Sachs Funding Profile In November last fragile. Ultimately, year, those of Bank the ability of a End 2006 End 2011 Funding source: of America Merrill (% of liabilities) fractional reserve 11.4% Payables Lynch traded bank to borrow at between 343 and a lower price than Short positions 4.25% 483 basis points. it lends governs its 10.6% Derivatives Why such volatility? profitability (via Repo 16.9% The short answer net interest margin) Reverse repo 67.7% is that the demise and its viability Other 117% of MF Global and (if it cannot anxiety about the borrow at all, it Short term debt 2.4% European sovereign Deposits will be insolvent).

Up from zero debt exposures But any loss of Long term debt 41.3% of certain banks funding forces a 96.7% and broker-dealers Equity bank to shrink its sparked a short% increases/decreases based on dollar amounts, not % of liabilities balance sheet by lived panic. But the Total a commensurate $838,201 $923,225 10.1% liabilities million million real answer is that amount, which in 23.4X 13.1X 44.0% turn means selling the panic was based Leverage (assets/equity) on sound reasoning. assets. In panicAll prime brokers stricken markets, remain reliant for anywhere between such as those of 2007-08, that implies 66 per cent and 86 per cent of their selling assets at fire-sale prices. Indeed, funding on some combination of repo as Tables 2 to 11 show, only one of the and money owed to customers, whether banks which survived the crisis without they are depositors, holders of credit acquiring or being merged (Goldman balances, or securities, repo, stock Sachs) has increased the size of its loan or swap counterparties. In other balance sheet since 2006. Citi, Credit 22

COO

COO Cover Story

Suisse, Morgan Stanley and UBS have nearly 50 pages is six times more than all shrunk their investment banking the eight pages Bear Stearns devoted balance sheets by anywhere between an to the subject of risk management in eighth and a third. its annual report for 2006, but it is still Yet the continuing reliance on sobering to read the aspiration expressed customer payables means that even there: “The company’s overall objective a temporary shortage of liquidity—a and general funding strategy seeks to simple inability to ensure liquidity Table 3: Morgan Stanley Funding Profile meet commitments and diversity of to return cash funding sources to End 2006 End 2011 Funding source: (% of liabilities) or securities to meet the company’s 16.1% Payables customers as they financing needs fall due—could at all times and Short positions 44.5% be fatal to any one under all market 19.2% Derivatives of these banks. environments.”

Repo 72.3% Nothing illustrates Much the same Reverse repo 79.7% this intrinsic language can Other 113% fragility better than be found in the the proportion of annual report of Short term debt 90.2% the annual report any investment Deposits 131.7% which the leading bank still extant Long term debt 27.0% banks devote to today for, in the 98.2% Equity explaining how life and death of they manage the % increases/decreases based on dollar amounts, not % of liabilities investment banks, wide variety of all risks ultimately Total $1,120,645 $749,898 33.1% liabilities million million credit, market, reduce to one. What Leverage 31.7X 10.7X 66.2% kills a bank is not operational and (assets/equity) especially funding losses on lending risks they face. (credit risk) or The ten investment banks studied for trading (market risk) or costs imposed this article devoted a grand total of 497 by regulators or fraudsters or technology pages of closely argued text to their risk failures (operational risk) but the impact management policies and procedures. of any one of these on the ability of Yet it is hard to see why anyone reading the bank to borrow money to fund its these torrents of verbiage would find assets (funding risk). This is why hedge them reassuring. True, an average of fund managers have to care about the 24

COO

COO Cover Story

ability of their prime brokers to fund themselves, because an investment bank that cannot fund itself cannot fund its clients. Unlike 2008, when the flight of hedge fund assets to prime brokers such as Credit Suisse, Deutsche Bank and J. P. Morgan was close to panic buying, hedge fund managers are now managing counterparty credit risk actively. They monitor their prime brokers continuously, looking for signs that funding is being withdrawn. Symptoms of deterioration include deposit withdrawals, rising funding costs, widening CDS spreads, increased initial or variation margin calls, shortening of debt maturities, heftier haircuts in the repo markets or failure to roll over a commercial paper programme. But hedge fund managers tend to rely on tracking CDS spreads, as likely to reflect all available information. In fact, most large funds now operate to trigger points. When a CDS spread passes a particular threshold, they automatically move balances to another provider.

The crucial anxiety level tends to lie between 350 and 450 basis points.

Threshold triggers of this kind are now being shared explicitly with investors, and even put into documents agreed with investors. They were put to some intriguing tests in the second half of last year, when markets were disturbed repeatedly by the decision

MEASURE YOUR FINANCING COSTS S

ince the Lehman failure, hedge funds have diversified their counter parties, largely at the behest of their investors. They have also started to scrutinise their sources of financing. At the same time, prime brokers have introduced more complex, risk-based financing and margining methodologies, in an effort to manage their own exposures to hedge funds as counterparties.

“Risk managers at prime brokers want to get smarter about how they understand and manage the risk in a portfolio, and how they set the margin to protect themselves from the hedge fund client,” says Liam Huxley, vice president, product strategy, at Advent Software. “When we first started talking to hedge funds about monitoring this in an automated way, it was the largest and most sophisticated, multi-strategy, multi-prime funds that understood the potential. Now it is becoming a common requirement at the smaller end of the market as well.” Those conversations date back nearly five COO

25

COO Cover Story

to downgrade the rating of the United last year credit assessments of these States, the unending European sovereign four institutions parted company with debt crisis, and the possible impact of the pack of investment banks, and by these events on the banking industry. The end-March 2012 had yet to completely issues came together in the collapse of restore their previous status. At the end MF Global at the end of October, after of March, the Morgan Stanley five year bets the firm had taken in the European CDS was trading at a premium of 140 government bond basis points to the Table 4: Jefferies & Company Funding markets forced it seven universal Profile into bankruptcy, banks engaged in End 2006 End 2011 Funding source: (% of liabilities) and it was alleged the prime brokerage Payables 351.3% that customer industry, and assets were Goldman Sachs at Short positions 89.1% misappropriated a premium of 63 Derivatives 3.7% as the failing firm basis points.

Repo 359.7% struggled to make Last year 74.6% Reverse repo margin calls. As also saw the 17.6% Other Chart 1 shows, creditworthiness Bank of America of the one French Short term debt 47.3% Merrill Lynch saw Deposits bank with a serious its five year CDS prime brokerage Long term debt 289.9% spread widen from business—BNP Equity 123.7% 172 basis points Paribas—reon 1 August 2011 % increases/decreases based on dollar amounts, not % of liabilities rated, on grounds to a high of 483 of its exposure Total $17,825 $34,971 95.9% liabilities million million basis points on to European Leverage 11.3X 9.9X 12.4% sovereign debt. The 25 November. (assets/equity) That of Goldman alleviation of that Sachs widened in problem, by the the same period from 145 to 420 basis long term refinancing operation launched points. Morgan Stanley saw its CDS by the European Central Bank (ECB) spread increase from 175 basis points to from December last year, is a vivid high of 589 basis points on 4 October. reminder of the existential importance The Citi CDS spread rose in the same of funding risk to the banking industry. period from 45 basis points to 362. As In fact, central banks have in the last Chart 1 clearly shows, from early August five years become an important source 26

COO

of funding to investment banks. Since their conversion to bank holding companies in September 2008, even Goldman Sachs and Morgan Stanley have had access to central bank money.

Indeed, they obtained access to it rather earlier than that, when the overnight repo market in the United States dried up in March 2008, and the Federal Reserve had not only to cut its lending spread from 100 basis points to just 25 and extend terms from overnight to 30 days, but set up the Primary Dealer Credit Facility (PDCF). This was the first time in the history of the Fed that it had lent money directly to brokerdealers. The PDCF was not closed until February 2010. The central bank simultaneously established the Term Securities Lending Facility (TSLF) to lend broker-dealers general collateral to fund themselves elsewhere. That facility remained in place until October 2009. A separate Commercial Paper Funding Facility (CPFF) ran from October 2008 to February 2010. The lesser known Temporary Liquidity Guarantee Program (TLGP)—launched in October 2008 to guarantee the unsecured debt of any banks that wish to use it—is still in place, though it actually closed to new issuance in December 2009.

Goldman Sachs, for example, says in its 2011 annual report that it had $8.53 billion of unsecured borrowings

years now. Huxley—who was CEO of Syncova Solutions until the company was acquired by Advent Software in the spring of 2011—certainly knew what to ask, having spent a decade and a half developing technology systems for the equity finance business. Having listened, Syncova developed a system that offers transparency into margin, and the reasons behind margin calls. Advent Syncova has had hedge fund users since 2009.

Ironically, the first users of the application were not hedge funds but prime brokers. Interestingly, when hedge funds started showing an interest in it, some prime brokers were reluctant about sharing the details of their margin methodologies with their buy-side clients, on grounds that the hedge fund that could optimise its use of capital would be a less profitable one. “There was a lot of wariness about what would happen if hedge funds understood the models,” recalls Huxley. “Over the last three or four years a lot of that wariness has disappeared. There has been an acceptance that transparency is required, and can actually improve the relationship. Now, even the more complex methodologies are being shared openly with clients. More and more prime brokers are standardising the data they share with us and COO

27

COO Cover Story

guaranteed by the TLGP at the end of last universal banks only, and not the balance year. Morgan Stanley had $12.1 billion sheets of their investment banking of TLGP-guaranteed debt outstanding arms—though, with the exceptions at the end of the same period. But both of Bank of America Merrill Lynch banks have reduced their reliance on and J.P. Morgan, the investment bank this facility, and on central bank funding accounts for at least three quarters of in general. While the consolidated Table 5: Bank of America Merrill Lynch access to central balance sheet of Funding Profile bank money the bank anyway.

End 2006 End 2011 Funding source: (% of liabilities) is a reassuring The tables are 192% Payables backstop in imperfect also Short positions 10.6% distressed markets, in the sense that 264.3% Derivatives it is not ideal. Other levels of disclosure creditors see it as a Repo make it hard to 1.2% sign of weakness. understand exactly Reverse repo At 50 basis points, what a particular Other overnight money liability on a Short term debt 74.7% from the Fed is also particular balance 48.9% relatively expensive, Deposits sheet actually and it is subject to contains, and Long term debt 154.9% aggregate exposure Equity how comparable 70.1% limits. It is hard to it is with similar tell from the annual % increases/decreases based on dollar amounts, not % of liabilities liabilities at other Total $1,459,737 $2,129,046 45.9% banks. These reports of the liabilities million million banks how much reservations apart, Investment $639,248 $637,754 0.2% Bank—IB million million use they make Tables 2 to 11 do IB as a % 43.8% 29.9% 31.7% divide the liability of central bank of balance sheet money, but it is Leverage 10.8X 9.3X 13.9% side of the balance (assets/equity) unlikely to be large. sheets of ten leading Which means they prime brokers into remain dependent primarily on the ten reasonably convenient categories, various sources of commercial bank and whose sustainability “at all times other private forms of funding sketched and under all market environments” out in Tables 2 to 11. The tables are (to borrow a phrase from the 2006 imperfect, in the sense that they show annual report of Bear Stearns) is worth the consolidated balance sheets of the examining.

28

COO

COO Cover Story

The exact nature of the first category—payables to customers and counterparties—remains somewhat opaque. Those to counter-parties, which appear on balance sheets as “broker payables” are not really funding at all, but simply items owed to counterparties in trades awaiting settlement at the time the balance sheet is struck.

Customer payables, on the other hand are interesting and important. Indeed, they are such a significant source of funding for the three stand-alone prime brokers—Goldman Sachs, Jefferies & Company and Morgan Stanley—it is reasonable to assume that they are primarily sums owed to prime brokerage clients. Payables arise when clients have positive cash balances with a prime broker after netting cash off against margin loans, so the prime broker owes the client cash. Short positions taken by a hedge fund with a prime broker also generate liabilities.

Selling the securities generates cash, which the prime broker uses to borrow stock to cover the short position, adding to securities borrowed on the asset side of the balance sheet, and to cash owed on the liability side of the balance sheet.

In the United States, of course, the use by investment banks of customer cash and securities to fund their own business is strictly limited by customer protection Rule 15c3-3, introduced by the Securities and Exchange

their clients, so the Syncova reports back to the hedge fund can be more comprehensive.” Acceptance by prime brokers that the era of single prime brokerage relationships is over has made it easier to accept that clients are entitled to know more, and that knowing more can lead to more business. “Prime brokers are always asking hedge funds to give them a slice of pie so they can show what they can do,” says Roy Alexander, a solutions consultant at Advent Software who previously worked in prime brokerage at both Morgan Stanley and Credit Suisse. “Syncova is a tool which prime brokers can use to substantiate their competitive edge.” He adds that it can help prime brokers run their own businesses better too. “Before 2008, prime brokers used to give out leverage like candy,” he says. “As soon as the credit crisis started, risk managers needed to be much more prudent about how they were extending leverage. It was about the capital of the investment bank as a whole, and prime brokerage comes pretty low in the hierarchy for capital allocations. Prime brokers needed to build tools to manage the exposure of their own book. Take convertible arbitrage. Before the crisis they took on as much business as they could.

After the crisis, they found they could not re-use much of the collateral, COO

29

COO Cover Story

Commission (SEC) in 1972 after multiple used by prime brokers to cover the short broker-dealing firms failed to keep track position—that is to say, the cash is used of proprietary and customer assets during as collateral for borrowing the stock the settlement crisis that led ultimately from an agent lender to cover the short to the formation of the Depository Trust position—so the risk is overnight only, & Clearing Corporation (DTCC). The and confined to the possibility that the workings of the rule value of the short Table 6: Barclays Capital Funding Profile are complex, but position falls, essentially require creating a demand End 2006 End 2011 Funding source: (% of liabilities) prime brokers to from the lender Payables 14.1% segregate sufficient for more cash Short positions 36.2% assets to cover the collateral. However, Derivatives 275.2% net credit balances if a prime broker of their customers lends the stock from Repo 51.4% at all times. It its own portfolio, it Reverse repo still allows prime gains access to cash Other 69.4% brokers to use client without having to Short term debt cash and securities fund it, though it to fund the business Deposits does of course lose 35.3% of clients with the control of the stock Long term debt 23.8% firm. And there is (the US segregation Equity 138.0% no such protection rules aim to ensure % increases/decreases based on sterling amounts, not % of liabilities in place outside the no extra liquidity Total £996,787 £1,563,527 56.9% United States, where can be transferred liabilities million million prime brokers have Investment from the short £657,922 £1,158,350 76.1% Bank—IB million million had much greater position to the 66.0% 74.1% 12.3% lender of the long freedom of action in IB as a % of balance sheet using and re-using Leverage 36.4X 23.9X 34.3% position, whether (assets/equity) client assets for their it is a prime broker own purposes. or a lender that In theory, short positions and provides the loan). This creates a larger securities borrowed are almost perfectly risk because a prime broker is a less matched, so the risk of a payables stable source of borrowed stock, because mismatch leading to a scramble for they trade more activity than clients of an either cash or securities is low. The cash agent lender, and are more likely to recall proceeds of short positions are usually it. However, there is no simple solution to 30

COO

COO Cover Story

the risk from the perspective of a hedge fund client. The terms on which a hedge fund can borrow cash or securities from a prime broker vary in line with the willingness to allow the prime broker to make use of—or re-hypothecate, as the term has it—their assets. Much of that re-use does not show up on the balance sheet. In its December 2011 annual report, for example, Morgan Stanley reported that the value of financial instruments received as collateral which it was permitted to sell or re-pledge was $48 billion. But it recorded elsewhere that no less than $335 billion worth was actually sold or re-pledged. Hedge funds that do not allow prime brokers to re-hypothecate their assets, or which insist on parking unencumbered cash and securities with third party custodian banks, find that the terms of business are less favourable. It has a substantial effect on the price of borrowing because the prime broker has in effect to advance its own money, rather than that of its clients. Hedge funds which insist on asset segregation pay a higher price, effectively geared to the rate the prime broker pays for long term debt.

If a prime broker can re-hypothecate assets, on the other hand, it can lend them to other customers, or pledge them in the money markets to raise funding for its own balance sheet. In theory, it can then share some of the consequent savings in funding costs with its hedge

Acceptance by prime brokers that the era of single prime brokerage relationships is over has made it easier to accept that clients are entitled to know more, and that knowing more can lead to more business. and were having to use the balance sheet of the firm to fund those assets.

Pre-crisis, many prime brokers did not have their hands around the profitability of each client, or how they were using the collateral of each client. They had to start thinking about how they charged for different types of collateral.�

For hedge funds, on the other hand, the combination of more (and more sophisticated) counterparties has massively increased the administrative burden. Prior to 2008, multi-prime was more an idea than a reality for most funds. Now it is a reality, and one magnified by the natural extension of counterparties that occurs when a fund moves into new asset classes, and the shift of swaps to central counterparty clearing houses (CCPs). Hedge funds are finding this multiplication of exposures has increased the time and effort consumed by daily financing COO

31

COO Cover Story

fund customers. If a hedge fund insists its can keep for themselves or share with assets are segregated, the scope to share customers. In fact, it is chiefly in their the benefits in that way disappears. ability to net the costs of lending cash Ultimately, the rate at which a prime and lending stock to different customers broker can lend cash to a hedge fund is that prime brokers can gain a competitive decided by the combination at which a edge in funding costs they can pass on prime broker can to their hedge fund Table 7: Citi Funding Profile fund the securities customers. It follows the hedge fund that the price of End 2006 End 2011 Funding source: (% of liabilities) is offering in the borrowing for hedge Payables 33.4% money markets, funds which agree Short positions 1.8% plus a spread to to assets being reDerivatives 24.8% cover the cost of its hypothecated will own balance sheet. Repo always be much 43.2% Similarly, on the lower than the price Reverse repo short side, the rate charged to those Other 16.5% at which a prime that do not agree to Short term debt 46.0% broker can lend assets being resecurities to a hedge Deposits 21.6% hypothecated. In fund is determined Long term debt other words, there is 12.1% by the rate at which Equity value to be derived 49.9% the securities can from agreeing to % increases/decreases based on dollar amounts, not % of liabilities be borrowed, plus re-hypothecation.

Total $1,884,318 $1,873,878 0.6% a spread for the Recent experience liabilities million million balance sheet. If a suggests most hedge Investment $1,077,787 $894,000 17.1% Bank—IB million million prime broker feels fund managers IB as a % 57.2% 47.7% 16.6% fully recognise this, the position of a of balance sheet long customer is Leverage 15.7X 10.4X 33.8% and that they are (assets/equity) stable enough, it can still comfortable lend his securities to agreeing to rea short customer, without needing to go hypothecation with the protection of to the market to borrow stock. The bigger SEC rule 15c3-3. They are much less a prime broker is, the more offsetting comfortable doing it via a non-US opportunities of this kind it will see. This agreement, or under the relatively loose internalisation of the bid-offer spread reinvestment criteria set by Regulation creates savings which prime brokers 1.25 of the Commodities Futures Trading 32

COO

COO Cover Story

Commission (CFTC), which may see their cash collateral effectively reinvested in money market instruments issued by some latter day Lehman Brothers or the euro debt obligations of the Hellenic Republic.

The second category of short positions is much more straightforward.

It records the physical short positions of the prime broker itself, and invariably includes an amount for net (of offsetting positions with the same counter-party and collateral received) payables on derivatives (which includes futures and options and forward rate agreements as well as swaps).

Both physical shorts and derivatives payables have offsetting positions on the asset side of the balance sheet, where the borrowed securities that cover the physical short positions are recorded, alongside net receivables from derivatives, so are more in the nature of accounting entries than funding risks. The same cannot be said of repo (securities pledged) and the much smaller reverse repo (securities loaned). Prime brokers tend to repo large volumes of government, agency, mortgage-backed, asset-backed and corporate bonds and equity holdings, for the obvious reason that clients borrow against the assets they hold with them, and these can be financed with cash-rich American regional and continental European banks that hold

and margining reconciliations with counterparties; the difficulty of predicting financing and stock borrowing requirements; the challenge of comparing financing and stock borrowing costs from different sources; calculating the cost and risk of the choices made; working out how to optimise the use of portfolios of cash and securities as collateral, including the identification of crossmargining opportunities; predicting the need to upgrade collateral for posting to CCPs; and deciding which prime brokers to retain, and which to reduce or terminate. In short, complexity increases the risk of being over-charged. True, not all hedge funds are bothered by this possibility.

Even now, some are happy just to cover the margin call, whatever the price of the money, especially at the lower end of the assets under management (AuM) spectrum. Hedge funds have always varied greatly in their ability to understand their cash and stock borrowing costs, and to use that information to manage their prime brokers. The multiplication of counter parties and asset classes is just making it harder for everybody.

Some care more than others.

What is clear is that failing to manage the complexity at all guarantees that financing and stock borrowing costs will be higher COO

33

COO Cover Story

cash, or money market funds that invest importantly, it is impossible to tell from in repo. This source of funding was put published accounts what proportion to the ultimate test in 2007-08 when of repo trades are actually funding the virtually all of these repo counterparts principal business of the bank (where fled the marketplace. There was at the the bank is taking market risk) and what time a poor appreciation of the scale of proportion are funding client business the risk posed by (where market risk Table 8: Credit Suisse Funding Profile reliance on cashis eliminated by the rich American and Funding source: matching assets on End 2006 End 2011 (% of liabilities) European banks the other side of Payables 105% and money market the balance sheet).

Short positions 51.6% funds to lend to The gross value of Derivatives 2.5% the domestic repo repo transactions markets against is also kept off Repo 38.8% client collateral. consolidated Reverse repo 6.8% Indeed, it was balance sheets Other 38.1% the experience of altogether by netting Short term debt 21.2% having to rescue of receivables the giant overnight Deposits and payables 9.0% repo market in with the same Long term debt 10.0% (inc. CoCos) the United States counterparties, in Equity 5.7% that prompted the a similar fashion Federal Reserve to % increases/decreases based on CHF amounts, not % of liabilities to the reporting CHF 1,255,956 CHF 1,049,165 16.5% of payables and set up the Tri-Party Total liabilities million million Repo Infrastructure Investment receivables net CHF 1,046,557 CHF 804,420 23.1% Bank—IB million million Reform Task Force, of counterparties IB as a % 83.3% 76.7% 7.9% and collateral which delivered of balance sheet its final report in Leverage 28.8X 25.5X 11.5% in derivatives (assets/equity) February this year. portfolios. In other Despite official words, the balance involvement at that detailed level, it sheet records a repo or reverse repo is still difficult to measure the scale liability only to the extent that the value of repo financing, not least because of the securities pledged or delivered activity at the level of the investment to the counterparty exceeds the amount bank is hidden in the larger balance of cash or collateral received. Goldman sheets of the universal banks. More Sachs, for example, recorded in its 2011 34

COO

annual report $41 billion of “credit exposure related to securities financing transactions reflecting enforceable netting agreements.”

Where securities are exchanged for securities, the transactions will not show up in the published accounts at all. It is interesting to compare, for example, the value of all that collateral sold or re-pledged

by Morgan Stanley at the end of last year ($335 billion) with the value of repo ($104.8 billion) and reverse repo ($30.5 billion) recorded on its consolidated balance sheet at the same date. The number is two and half times as large. That said, the ability to net implies, of course, a high degree of matching between receivables and payables, securities pledged and securities received as collateral, and in terms of counterparties. So the ability to shrink the asset and liability sides of the balance sheet in tandem is high if the repo markets begin to withdraw funding from the bank.

However, the matching of maturities— it is, incidentally, impossible to gauge durations from published information—and collateral types and counterparties can never be exact.

Neither Bear Stearns nor Lehman Brothers nor MF Global was able to collapse both sides of their balance sheet fast enough to avert catastrophe.

Inevitably, if funding is withdrawn

than they need to be. “As you start to spread your collateral among more counterparties, the need to get your hands around the data, and to understand the demands being placed upon your portfolios, has become increasingly important,” says Alexander. “It is a prime determinant of costs.” Clearly, a balance needs to be struck if financing relationships are not to become fractious. Continuous wrangling over the accuracy of margin calls and invoices can steadily undermine relationships with prime brokers, potentially prompting them to re-rate a fund as a client in terms of the support they wish to offer. On the other hand, careless management of trading balances or concentration limits gives a prime broker the opportunity to terminate a margin lock-up agreement. In this way, the sub-optimisation of the financing potential of a portfolio can directly reduce the buying power of a hedge fund, meaning opportunities are not fully exploited, or are missed altogether. It can also affect the accuracy of performance measurement. If the cost of borrowing cash or securities is not calculated accurately and attributed to the right trades, the return on trading positions will not be accurate either. The true cost of capital, in other words, is obscured. Indeed, there is a risk COO

35

COO Cover Story

from the liability side of the balance so their deposits tend to be more sheet, sales from the asset side are bound institutional and less retail in nature, and to be made into illiquid and risk-averse are therefore less adhesive than retail markets. In any market where a major money underpinned by public deposit investment bank cannot fund itself in the insurance. Although the bulk of retail repo market, a wide gap between assets deposits are repayable on demand—only and liabilities is a fraction can be Table 9: Deutsche Bank Funding Profile near-certain to secured for a period open up. of years—outside End 2006 End 2011 Funding source: (% of liabilities) This is why the most extreme Payables 1,413.1% hedge fund market conditions, Short positions 37.2% managers shifted when even retail Derivatives 113.7% assets to universal deposit insurance is banks in 2007no longer credible, Repo 65.4% 08. Their chief they are the most Reverse repo 61.8% advantage over inexpensive, stable Other 95.2% stand-alone and sustainable Short term debt 34.9% investment banks is source of funding.

Deposits access to funding This is the primary 46.1% from deposits. As reason why Long term debt 51.3% Tables 5 to 11 show, Equity investment banks 63.3% deposits account for reliant on wholesale anywhere between % increases/decreases based on euro amounts, not % of liabilities funding exhibit €1,584,493 €2,164,103 36.6% higher CDS spreads a quarter and half of Total liabilities million million the funding of Bank Investment than universal €1,468,321 €1,727,156 17.6% Bank—IB million million of America Merrill banks. That said, IB as a % 83.3% 79.8% 4.2% the retail deposits Lynch, Barclays, of balance sheet Citi, Credit Suisse, Leverage 28.8X 39.6X 37.5% of the banks are not (assets/equity) Deutsche Bank, available to fund J.P. Morgan and hedge fund clients, UBS. At Goldman Sachs, which now except for a small proportion owned by has a deposit-taking arm, the equivalent high net worth investors unconstrained is a twentieth. At Morgan Stanley, also by retail regulation. Even they have now a deposit-taker, it is less than tenth. specifically to agree that their deposits The two firms have wealth management can be used to fund hedge fund clients arms but lack retail distribution networks, of the bank. In fact, Federal Reserve 36

COO

Rule 23A prevents American banks from using client deposits in their broker-dealing subsidiaries. Though this has not always prevented distressed firms from misappropriating client cash, the rule does limit the utility of deposits to a prime brokerage business.

The real value of deposits in terms of competition for hedge fund business lies in the perception that the bank is better able to withstand periods of extreme stress in the funding markets.

The remaining three categories are short term debt and long term debt and equity. Short dated debt, which consists of certificates of deposit, structured notes, covered bonds secured on customer loans and advances or commercial paper and asset-backed commercial paper, is not a large proportion of the balance sheet of any bank today. Prior to the crisis, many banks borrowed significant sums in the commercial paper markets, but the appetite of cash providers for financial issuers has shrunk since the market dried up in 2008 and had to be rescued by the CPFF. What constitutes short term borrowing is not always easy to discern from published accounts but, as Tables 2 to 11 show, they rarely account for more than a twentieth of liabilities. Loss of access to short term debt markets would not be immaterial, but it would be manageable. Long term debt, on the other hand, has increased

of incurring additional costs, such as an excessive margin call, or an unnecessarily costly stock borrow, or even a requirement to liquidate a position in order to meet a margin call. “You never want to find yourself in a position where you are forced out of a trade because of an operational issue,� warns Liam Huxley.

If the cost of borrowing cash or securities is not calculated accurately and attributed to the right trades, the return on trading positions will not be accurate either. The true cost of capital, in other words, is obscured.

There is another reason to stay on top of financing costs. This is the growing burden of reporting. Investors are pressing hedge fund managers not only to run their financing and stock borrowing processes more efficiently, but to show how they are actually doing it, and on a continuous basis. With regulators now seeking detailed reporting of the positions of a hedge fund as well as its leverage and concentration risk—Form PF is the classic exemplar of this, but COO

37

COO Cover Story

significantly as a proportion of funding sheet funded by equity. Unfortunately the at every bank save Barclays. This is share prices of the publicly listed banks deliberate, and reflects the efforts of have not responded especially strongly banks to both shrink and steady their to the improved revenues of recent years, balance sheets, with stern encouragement chiefly because of underlying concerns from regulators anxious to de-leverage about the stability of balance sheets. the financial In fact, the share Table 10: J.P. Morgan Funding Profile system. The main price of a bank is risk is that the sheer Funding source: an important gauge End 2006 End 2011 (% of liabilities) volume of long of its financial Payables 130.3% term debt—the strength, especially Short positions 26.3% ten prime brokers relative to other Derivatives 30.5% featured in this banks. The share article had $1.9 prices of both Repo 31.7% trillion of long term Reverse repo Bank of America debt outstanding at Merrill Lynch and Other 307.7% the end of 2011— Citi, for example, Short term debt 99.3% proves difficult to have suffered Deposits re-finance on the from assessments 76.6% timetable dictated of the quality of Long term debt 76.3% by maturity dates. their assets. Some Equity 58.5% Equity, of European banks, course, is the most % increases/decreases based on dollar amounts, not % of liabilities on the other hand, Total $1,351,520 $2,265,792 67.6% have had to address stable funding of liabilities million million any, since all other difficult questions Investment $647,569 $776,430 19.9% Bank—IB million million liabilities must be on their exposure to IB as a % 47.9% 34.3% 28.4% European sovereign discharged before of balance sheet equity holders Leverage 11.7X 12.3X 5.1% debt. Those (assets/equity) are even paid a questions were dividend. This is searching enough at why regulators would like banks to issue one point last year to deny them access to more common stock, and manufacture the US dollar money markets, forcing the more equity via retained earnings. As Federal Reserve to agree swap lines with Tables 2 to 11 show, each of the ten prime the ECB. brokers featured in this article has already But it is also important to remember increased the proportion of its balance that the share price of a bank can weaken 38

COO

for reasons other than an unconvincing balance sheet—including, paradoxically, the earnings problems occasioned by a heavily capitalised balance sheet. This is an issue for almost every one of the publicly listed banks active in prime brokerage.

Indeed, the only prime broker featured in this article which does not also appear on the Financial Stability Board (FSB) list of 29 globally systemically important financial institutions (G-SIFIs) subject to additional capital requirements is Jefferies & Company.

The G-SIFIs had hoped the regulators would allow them to meet at least some of the additional requirements by issuing the debt-equity hybrids known as contingent convertible bonds (so-called CoCos, which convert into equity if capital ratios deteriorate below a certain point). Credit Suisse managed to issue $2.75 billion of CoCos in two tranches this year and last, and has privately placed a further $6 billion, to start in October 2013 Barclays and Deutsche were expected to follow suit, but the regulators insist only common stock and retained earnings count as Tier One capital. So an inverse relationship between sheet strength and share price performance will persist, which any credit assessment must take into account.

The rising cost of capital has profound implications for the terms on

regulated funds make similarly burdensome demands—the appetite for services that enable firms to outsource the task and for technology to automate it is growing. Some describe this appetite as a demand for better collateral management, in which the contents of portfolio are ascribed to their optimum use in repo, reverse repo, and CCP margin calls. Indeed, Advent is now adding SWIFT messaging functionality to its platform to automate CCP margin movements, and looking to add an interface to the Depository Trust & Clearing Corporation (DTCC). But Liam Huxley strongly resists the categorisation of Advent Syncova as comparable with either collateral management systems (of which the best known are supplied by Algorithmics and Lombard Risk) or margin call automation tools (such as those offered by Acadia Soft or Calypso) or third party collateral management services of the kind offered by global custodian banks (such as BNY Mellon and J.P. Morgan) that aim to help buyside firms post, value and retrieve collateral. Though those systems and services can automate the workflows associated with posting collateral to multiple counterparties in line with standard International Swaps and Derivatives Association (ISDA) COO

39

COO Cover Story

which hedge funds can do business with adequacy regime) but it has not proved investment banks. Every year, a bank especially lucrative in the last three or has to divide its balance sheet between four years. The recovery of balances lifted competing claims upon it. At a universal prime brokerage revenues at Goldman bank, there is a second division of the Sachs and Morgan Stanley in both 2010 spoils at the investment bank level. In the and 2011, but the improvements really end, every business reflect the recovery Table 11: UBS Funding Profile division has to live of ground forfeited within the share of Funding source: in the crisis, when End 2006 End 2011 (% of liabilities) the balance sheet its Payables balances sank 19.2% senior management precipitately. The Short positions 80.7% garners, and prime revenues of the 42.4% Derivatives brokerage is no equities division at different from any J.P. Morgan, which Repo 81.2% other business in includes prime Reverse repo 19.3% that respect. The services, were more Other division which or less flat in 2011.

Short term debt 38.9% makes a lot of At UBS, prime Deposits money at low service revenues 51.9% risk on a modest were actually down Long term debt 26.0% allocation of capital Equity 3 per cent last year, 3.7% will always increase albeit partly because % increases/decreases based on CHF amounts, not % of liabilities its share of the of the weakness of Total CHF 2,396,511 CHF 1,419,162 40.8% balance sheet, while the US dollar versus liabilities million million the business which Investment the Swiss Franc.

CHF 2,058,679 CHF 1,073,600 47.9% Bank—IB million million makes not-a-lot of Credit Suisse had 85.9% 75.7% 11.9% the same problem. money at high risk IB as a % of balance sheet off a large allocation Leverage 42.9X 24.5X 42.9% Revenues were (assets/equity) of the balance sheet down at Deutsche will find its capital Bank too last year, allocations shrinking. Prime brokerage, and equities and prime services revenues run without chasing market share on at Barclays declined by 14 per cent in price and with the right type of haircuts 2011, though it was equity financing that applied to client collateral, will generally prevented an even steeper decline. be judged to be relatively capital-efficient Static to falling revenues are a (even under the tighter Basel III capital reminder that, beyond any allocation 40

COO

of capital to a particular business division, the revenue and profitability of an investment bank ultimately depends on daily funding decisions that are specific to clients, and to client types and collateral types, and can be heavily influenced by currency movements. Nevertheless, the starting point of any discussion for a prime broker with a hedge fund client is still the average cost of funding, which is based on its own cost of borrowing, not only in the money markets, but in the capital and collateral markets also.

The pricing and terms of borrowing are more sophisticated now than they were five years ago, when every client paid the same debit rate. Nowadays, a statistical arbitrage fund, whose trades are short and liquid and margins thin, will borrow cheaper money overnight than a convertible arbitrage fund, who will prefer to pay more for three to six month money that can keep it in the trade, eliminating the risk of unwinding it at a loss when funding is pulled.

Astonishingly, distinctions of this kind were virtually unknown in prime brokerage five years ago. In those days, every fund was quoted much the same rate, because every prime broker was charged much the same rate in the repo market, irrespective of the collateral they offered. As it happens, the current environment does not encourage hedge funds to put on highly leveraged carry

agreements and Global Master Repurchase Agreements (GMRA), and offer help putting each piece of collateral to its optimum use, they do not do what Syncova does: help users understand and support complex, riskoriented margin models. “We are more of a collateral analysis than a collateral management system,” explains Huxley. “Our hedge fund clients are more focused on the analysis and optimisation of their agreements, including both their complex prime brokerage models and the more traditional ISDAs. We use the funds’ own view of their cash and non-cash collateral, and identify opportunities to better use and allocate it.”

“We are more of a collateral analysis than a collateral management system.”

This is an important distinction.

A third party collateral manager will suffer always from the limitation that he cannot make investment or financing decisions. Advent Syncova, on the other hand, looks not only to generate the information that informs the decision, but to provide the tools that assist in the implementation of the decision. It provides `What if?’ scenario planning tools; compares margin costs from prime brokers COO

41

COO Cover Story

trades anyway, so there is a shift among clients as well as prime brokers towards term rather than overnight financing. The price of the money, inevitably, is higher.

It is likely soon to get higher still.

Increased capital and liquidity ratios imposed on G-SIFIs and other banks are only the most conspicuous and direct of a series of regulatory initiatives which are bound to increase the price at which prime brokers can lend money and stock to hedge fund managers. In Europe especially, but also in those parts of Dodd Frank that promise higher capital ratios for securities lending and derivatives, lurk “shadow banking” initiatives that aim expressly to suppress the twin essences of the prime brokerage industry: securities lending and securities financing. Yet the details of even apparently unrelated regulatory measures are also having an impact on the cost of cash and collateral in prime brokerage. Swap clearing on a centralised basis, which may be extended to securities lending, is likely to lead to a shortage of general collateral. The “hard locate” section of the European short selling regulation may also drain collateral from the equity markets. Reform of money markets funds in the United States, designed to shorten their maturity profiles, will reduce the appetite for term repo just as demand from hedge funds goes up. Greater disclosure of short 42

COO

sales, definitely under the European short selling regulation and perhaps under Dodd Frank as well, will drive counterparts out of the stock loan markets. Revisions to the European UCITS regime proposed by the European Securities Market Authority (ESMA), which aim at regulating stock lending by ETFs in particular, will reduce supply and raise prices in European equity lending. The Volcker Rule will make prime brokers more expensive as well as less well-informed counterparts, by restricting their market-making activities. The single counterparty credit limits of Section 165 of Dodd Frank, whose coverage includes securities loans, repo and reverse repo, will certainly increase the price of borrowing money and stock.

That same Section 165 aims to restrict the leverage ratios of systemically important domestic and foreign banks active in the United States to a maximum of 15:1, including assets currently held off the balance sheet. Not many of the investment banks featured in this article could match that demand today, yet the sharp reduction in leverage which has occurred since 2006 is the most striking symptom of everything that has changed since that antediluvian year. Back then, a Bear Stearns balance sheet leveraged 28.9 times did not seem especially reckless. At 26 times equity, the Lehman Brothers balance sheet of 2006 was

actually less leveraged than the then average (32 times) across Barclays Capital, Credit Suisse, Deutsche Bank, Goldman Sachs, Morgan Stanley and UBS. We now know, of course, that Lehman Brothers was deliberately concealing the scale of its leverage through the use of the infamous Repo 105 technique, which in late 2006 was keeping about $25 billion of liabilities off its balance sheet. But even adding those liabilities back in does not fundamentally alter the fact that Lehman Brothers, like Bear Stearns, was managing its balance sheet in much the same way as any other bank. Five years on, leverage is down by nearly half at Goldman Sachs (see Table 2), two thirds at Morgan Stanley (see Table 3), a third at Barclays and Citi (see Tables 6 and 7) and two fifths at UBS (see Table 11). If this is more than a cyclical phenomenon, and it almost certainly is—at least for this generation—the hedge fund industry is going to have to learn to live with fewer spectacular opportunities for gain through leverage, as well as more expensive financing tout court. The irony of this will not be lost on hedge funds concerned about the funding profile of their prime brokers. Regulators are clearly worried about the same thing. The difference is that regulators want the industry to get smaller as well as safer.

“They were able to identify numerous discrepancies in the charging by counterparties, which resulted in millions of dollars of mistakes being identified, which dropped straight into their P&L.” side by side; matches margin calls against terms agreed with each prime broker; validates the accuracy of debit financing and borrow charges; automates the recording and tracking of stock loan locates and pre-borrows; identifies lower borrow rates through rate comparisons; and attributes funding costs at the level of the investment strategy, or the trade, or the individual portfolio manager. Syncova achieves these goals largely by making the necessary information-gathering more efficient. Huxley references an Advent client that purchased the system. A mid-sized multi-strategy hedge fund with a few billion dollars in assets under management in several sub-funds, and multiple prime brokerage relationships, it was entirely reliant on manual processes.

Operational staff were monitoring prime broker statements on a daily basis. This worked well enough when COO

43

COO Cover Story

the fund had only one prime broker.

Once it appointed a second, and then a third, data and data formats became fragmented, and data had constantly to be re-keyed. Valuable time was lost before problems were identified. The firm found that the only way to scale this manual process was to throw more bodies at it, which increased costs. Even with more bodies, the fund manager found it was unable to validate its financing and margining charges, or maintain the right level of collateral at each of its counterparties, or report accurately on these issues to its own CFO, let alone investors or regulators. It was then that the fund bought Advent Syncova. “They got some great results,” says Huxley.

“They were able to identify numerous discrepancies in the charging by counterparties, which resulted in millions of dollars of mistakes being identified, which dropped straight into their P&L. They were able to move positions between counterparties, optimising their value as collateral, cutting their margin costs. They were also able to improve their understanding of their trading P&L on each of their strategies. By automating the process, they were even able to reduce their operational headcount.”

Though that fund was an Advent client, it is not necessary to be an Advent Geneva customer to make 44

COO

use of Advent Syncova. Of course, a client using both Geneva and Syncova will enjoy the benefit of pre-existing feeds of the price and position data the Syncova system needs. Being part of the Advent group has also enabled Syncova to offer the platform on a hosted basis, where hedge fund users can simply send internal and counterparty files on a daily basis for remote analysis. This service, dubbed Syncova Essentials, is aimed primarily at the smaller funds in the Advent distribution network. “But Syncova Essentials is not just for smaller funds, because it adds value for funds of any size,” cautions Huxley. “Even some very large funds run lean technology operations. But some large funds prefer to have more control over their systems, and are happy to invest more in them, which is why we offer an alternative means of accessing Syncova.” This alternative is a locally installed application, where it sits on the servers of the fund, and consumes data from both the fund and its counterparties directly, replicating it live. The local version is sold on a standard software licensing model, with a flat annual licence fee unrelated to the number of users or counterparties, but which increases with both the size of the fund and the functionality required.

The hosted model is purchased via a monthly subscription, whose size

varies in line with the number of counterparties. Neither Huxley nor Alexander will venture an opinion on the payback period required, on grounds that the Syncova tool can be judged only in practice and on behalf of a particular portfolio. The ability of its attribution functionality to identify trades whose rate of return is low in relation to the collateral consumed, for example, needs real trades to work with. “The savings from the initial implementation are easy to quantify, but the economies achieved on an

ongoing basis depend on the specifics of each client,” says Alexander. “On the margining side, the ability of a hedge fund to put on more trades is governed not only by the potential of its own portfolio, but by the margin requirements set by the prime brokers.

If your margin calls are inaccurate, or just not optimised, you may have to liquidate portions of your position to meet margin call. The value added by a tool such as Syncova is that it minimises the risk of those situations arising in the first place.”

Eight ways Advent Syncova might help • Compare margin costs from different prime brokers side by side • Match margin calls against terms agreed with each prime broker • Put assets to their optimum use as collateral • Validate the accuracy of debit financing and borrow charges • Track stock loan locates and pre-borrows automatically • Identify lower borrowing rates through side-by-side rate comparisons • Check funding costs by strategy, trade, or manager • Compare predicted versus actual costs—and contest over-charging

COO

45

Sponsored Section

WHY IT MAKES SENSE FOR HEDGE FUNDS TO COLLECT CLASS ACTION PAY-OUTS Hedge funds need to make a more

capitalisation losses. With billions set aside

concerted effort to follow through with

for damaged investors, hedge funds have

collecting funds due to them from securities

a fiduciary responsibility to file claims and

class action settlements.

collect their share of the settlement funds

Securities class action settlements are

on behalf of their investors. Many hedge

funds earmarked to compensate investors

funds, however, have not made any efforts

damaged as a result of alleged securities

to pursue recovery of damages against

law violations, including fraud, non-

investments where they have incurred

disclosure or misrepresentation of facts.

losses.

A class action is a civil court procedure

“A major factor as to why hedge

under which one party, or a group, may

funds do not pursue these cases is time,”

sue as representatives of a larger class.

comments Mark Donaldson, Managing

To continue in the court system as a class

Director and founder of Battea—Class

action, the court must certify the class

Action Services, a class action recovery

and the class must be notified. All class

firm focused exclusively on the securities

members are given the opportunity to

class action space. “A typical class action

exclude themselves or opt out. All class

settlement pay-out can take as long as

members that do not opt out are bound by

five to seven years after the fraud to

the judgement in the case.

happen. This is a long-time frame and

In 2010 and 2011, 364 securities class

many managers do not believe it is viable

action lawsuits were filed, representing

or worthwhile to wait that long. Also,

hundreds of billions of dollars in market

some managers may feel such cases

46

COO

could distract them from their day-to-day business.”

Battea, which works with over 300 institutional investors, the bulk of which are hedge funds, calculates securities class action settlement recognised losses or “damages,” and the resultant payouts, using proprietary algorithms applied to the clients’ trading data. Battea then files all claims on behalf of investors, collects settlement monies, reconciles with claims administrators, and provides

Sponsored Section

comprehensive reporting around the entire process via its website.

“For clients today, it is all about transparency, compliance and performance,” says Donaldson. “Clients love us because we send them cheques and enable them to focus on their core business by handling claims filing and recovery.”

Mark Donaldson, Managing Director and founder of Battea—Class Action Services

Many funds may also be reluctant to take further action against claims if the amount is nominal. This, argues Donaldson, is a mistake. “Some of the bigger frauds such as Madoff—a fraud but not a securities class action—and Enron have thousands of litigants wanting to get money which they feel they are entitled to,” he says. “Because of the high number of claimants, the proration—the proportion of settlement funds that is paid out compared to losses, such as 10 cents paid out for each dollar loss—can be much smaller. If the figure is smaller, there are going to be few claimants, which therefore means the settlement claim for the hedge fund will be larger.”

COO

47

COO Investor

Brain not brawn As head of research at a fund of hedge funds, Ben Funk gets to indulge his taste for qualitative research and quantitative risk management. Somehow, he has also managed to acquire along the way an MBA and doctorate, and indulge a private passion for star-gazing.

B

en Funk spent last Christmas in the Atacama. The thousand kilometer strip west of the Andes in northern Chile is reputedly the driest place on earth. But what attracted the head of research at Liongate Capital Management, the $3 billion London-based fund 48

COO

of hedge funds, was not just the opportunity to escape a rain-soaked British Christmas. The Martian landscape of the Atacama, with its high altitude, non-existent cloud cover, dry air, lack of light pollution and minimal radio interference, is the destination of choice for astronomers

COO

49

COO Investor

and astro-photographers eager to realise I was right to not pursue it”) capture unusual pictures of the and looks back with nothing but stellar nightscape. “The majority of fondness to his days on the trading space agencies, including NASA and floor. “Those were the days when it the European Space Agency, have was all very uncivilised and there observation outposts in the Atacama were people running around the Desert because of its excellent floor screaming,” he recalls. “It was visibility of space,” explains Funk, interesting to experience and see how a keen photographer of the visible trading happened in the free for all universe. “Astro-photography is a market, and I enjoyed my time there. genuinely phenomenal art form. It However, I wanted to do something requires keeping a camera lens open different with my career.” The change for minutes, or even hours, taking of direction was radical: Funk opted long exposure images to capture to read for an MBA specialising scant light. It is in finance at the unbelievable what University of The more I learn the camera picks Stockholm. “I about law, the more up, which the just wanted to I realise I was right do something naked eye cannot see, especially in in Europe,” is to not pursue it.

Atacama.” his riposte to the It is not a bad inevitable question. “I metaphor for successful investing really liked London but I thought its either, though the isolation and culture was too similar to the United tranquility of the desert is certainly States, so I opted for the University far removed from the Chicago Board of Stockholm business school. It was of Trade (CBOT) trading floor where a course that was in English, and Funk started his career. Having the MBA programme was not too graduated in political science from dissimilar to what was on offer in the Purdue University in Indiana in 1996, United States.”

Funk ditched his early ambition MBA in hand, Funk joined of becoming a lawyer to immerse Morgan Stanley. “I was employee himself in one of the noisiest number 44,437,” he says. “I started environments known to the world out on the training programme by of work. He has no regrets (“The being merged into a freshly minted more I learn about law, the more I class in New York. It was a good 50

COO

Over 300 of the World’s Smartest Investors Trust Battea’s Class Action Recovery Services

Billions in settlement dollars will be paid out to investors.

Is your firm collecting its share?

As a investment manager, your firm has a fiduciary responsibility to collect securities class action settlement funds on behalf of your investors.

Let Battea guide you on the road to class action recovery excellence.

Battea – Class Action Services is the leading provider of securities class action settlement recovery services to the institutional investment community.

Through our proprietary technology platform, The Claims Engine®, Battea – Class Action Services maximizes award recovery across all asset classes for more than 300 institutional investors, including hedge funds, asset management firms, sovereign and pension funds, endowments and family offices.

Battea provides a full-service solution for the entire securities class action award recovery process — from calculating recognized loss for every claim through the confirmation, receipt and delivery of settlement payouts. · Track record of excellence since 2001

For a free analysis of your firm’s class action settlement eligible filings, please contact: Jennifer Carberry at jcarberry@battea.com.

· Unparalleled transparency via our online client portal · Fully SSAE 16 Compliant · Exclusive focus on securities class action recovery · Global Coverage

Stamford, CT San Francisco, CA

203.987.4949 sales@battea.com

www.battea.com COO 51

COO Investor

experience and I got to move around different departments in New York and Chicago.” In 1999, Funk was transferred from New York to a considerably smaller office in Chicago, housing just a few hundred employees. It was there, in the city that is home to such notable names in the world of hedge funds as Citadel and Glenwood, that Funk was introduced to alternatives.

“Morgan Stanley wanted to start up a prime brokerage office to service Chicago and Minneapolis,” he explains. Managers in the two cities, both of which sport sizeable hedge fund communities, were still being serviced out of New York.

“We had good relations with a lot of Chicago-based hedge funds and we wanted to win a share of the market,” says Funk. “I co-authored a business plan for opening up a prime brokerage unit in Chicago and we pitched it to Philip Purcell, the then chief executive officer at Morgan Stanley. He gave us the nod and we implemented the plan.” Working in the Chicago office appealed to Funk, since it was similar to running a boutique, but with all the advantages of belonging to a major investment banking house. “The Chicago office is very far removed from the New York mother-ship,” he says. “It was fantastic to work at.”

52

COO

The experience Funk acquired in Chicago was ideal preparation for Liongate (his role was to analyse hedge funds, albeit to ensure the firm was offering them relevant products) but he did not stay long.

In 2001 Morgan Stanley moved him to London, where his appetite for the life of the mind (he is a visiting lecturer in economics at DePaul University) soon tempted him again.

“I wanted to further my studies and attain a PHD, so I left Morgan Stanley,” says Funk. “I was offered a fellowship at Cambridge University.

Now Cambridge is a wonderful brand and a great place, but the course they were offering at the Judge Business School was new and untested. It would have required me to write a paper on my own for three years.

That did not entirely appeal to me.

I wanted to stay close to people in finance, so I felt that it was better to remain in London.” Having spurned the Cambridge offer, Funk enrolled at the London Business School. Its curriculum, he says, was more in line with the established American model.

A PhD in what Funk calls “core finance and hard stats” provided the transition into research at Liongate.

“My PhD paper focused on merging finance and decision sciences in order to forecast hedge fund performance,” he explains. “I quantified variables

COO Investor

at newer and older funds to identify initially on managing internal capital what made a successful business. and keeping assets at a low level, It was about trying to understand but Funk and Holland had larger the dynamics which make larger ambitions. “As in any partnership companies successful and what the there have been some healthy drivers were for enabling smaller differences of opinion,” explains organisations to thrive.” There was Funk. “Randall, as a seasoned serendipity at work too. It was just as financial professional, was more he was completing his doctorate in content with us managing internal 2003 that he met Randall Dillard and capital. However, Jeff and I were Jeff Holland. younger and we wanted to grow the Dillard, a former managing firm and progress our careers. We director and head of merchant had not yet fostered the growth of a banking at Nomura, big business like and Holland, I think the last thing Randall had.” In previously a financial markets the world needed in vice president in hurtling out of the investment 2004 was yet another control in the banking arm of years immediately multi-strategy fund Deutsche Bank, prior to the crisis, of hedge funds. were in the process fulfilling those of setting up a fund growth ambitions of funds. Liongate required a point of Capital Management did not aspire differentiation. The solution at to become the next Blackstone.

Liongate was a top-down approach It launched in April 2004 with to capital allocations. “Having a friends and family seed capital, at a bottom up approach was valid in time when the market was already 2000 but it was outdated by 2004,” saturated with competitors. “I think explains Funk. “Funds of hedge the last thing the world needed in funds simply went after the same 2004 was yet another multi-strategy managers, which led to correlated fund of hedge funds,” jokes Funk. and undifferentiated returns. We built “Although we were one of the later a process that sought to identify and multi-strategy funds of hedge funds overweight investment strategies to set up, we actually survived the that better suited the current market crisis.” The business was focused environment, while reducing COO

53

COO Investor

exposure to strategies where there of the portfolio by May 2008 (“We was volatility, illiquidity or bigger did not make money on long/short headwinds, irrespective of historical equity in 2008, but we did not lose returns. Oftentimes, we looked any either”) and hedging. “10 per to initiate or increase exposure to cent is a significant loss, but relative managers who had been suffering to our peers it was a good loss, if poor performances, like short-bias there is such a thing,” says Funk. credit managers in the run up to “We kept our exposure to event2007.” driven equity managers or activist By 2007, credit spreads had hedge funds. These investments tightened to levels which seemed lost us cash, but we had hedged it unsustainable, and any short-biased by adding a significant exposure to credit manager was haemorrhaging volatility arbitrage managers with assets. Supporting managers prepared a long volatility focus. All of these to short credits in 2007 proved an decisions were unfortunately not exceptionally valuable intuition. enough to give us positive returns “We thought there was going to be but it certainly prevented far bigger a widening of spreads so we tried to losses.” But if Liongate navigated the find short-biased managers,” says crisis more successfully than some, Funk. They did, switching out of long it did not insulate the firm from credit at a handsome profit to back redemptions. “Unlike a lot of other three short bias funds of hedge credit managers.

Because we did not funds, we had near The decision was perfect liquidity change liquidity one of three that in our portfolio so helped to ensure terms and returned we did not need that Liongate, to gate or impose client money in unlike many other side pockets,” funds of hedge good time, we were explains Funk. funds, survived “We did think we back to over peak 2008 with distinctly would have fewer assets within a year. redemptions, given manageable losses of less than 10 per our performance, cent. The others were savage cutting but redemptions were of long/short equity exposures everywhere during the panic. throughout 2007 to just 1 per cent Because we did not change liquidity 54

COO

COO Investor

terms and returned client money in also enhanced its risk management good time, we were back to over peak systems and brought in internal assets within a year.” programmers and statisticians to Returning to peak assets did work alongside the risk managers. entail some change in the nature The challenge, however, is to balance of the clients of the firm. In the institutional quality and size with the years immediately prior to the nimbleness which enabled Liongate crisis, Liongate had evolved from to navigate the crisis so successfully. managing family wealth into a wealth “We want to be institutional but management business that counted a we want to remain boutique,” says number of high-net worth individuals Funk. “We do not have aspirations to and even some smaller institutional become the next $10 or $20 billion investors as clients. shop.” Remaining relatively Since the crisis, small does have We want to be Liongate has advantages. become far more Numerous institutional but institutional. An academic studies we want to remain industry whose and industry boutique. We do not surveys and reports reputation was battered by a crisis have aspirations to have confirmed which exposed its how nimbler become the next $10 inability to live up organisations to its promises—not or $20 billion shop. almost invariably least the exposure of generate higher some to the Madoff returns from hedge fraud—had to reinvent itself for fund investing than their larger institutional investors, which had competitors. “Managing a moderate proved far steadier than their retail amount of capital has its positives,” counterparts. “We increased our says Funk. “If an organisation grows headcount quite a bit and bolstered too quickly, it can lose its ability our investor relations department,” to invest in niche hedge funds. It explains Funk. “There was no is much more difficult to change shortage of people to hire as so weightings in the portfolio and, much talent had been laid off by frequently, large funds of hedge funds hedge funds and funds of hedge have to write big tickets to big hedge funds during the crisis.” The firm funds, leading to correlated returns.”

56

COO

COO Investor

That said, Liongate is scarcely essential to be a jack of all trades, and a minnow, with offices in Zurich, you feel more attached to the business.

Malta, Mumbai and New York as If you make a mistake, you feel it well as London these days. “We have more, as do your colleagues.” Unlike 55 employees and offices in five investment banks, the overwhelming cities now, so we are more complex majority of hedge fund and fund of and have a lot of bodies running funds managers eat their own cooking, around,” admits Funk. “However, the as the phrase has it. The success of culture is very familiar and we are all their investors is their success too— friends and family.” Predictably, he and Liongate is no exception. Indeed, rejects the idea of moving to a larger employees own the largest slice of fund of funds house or re-joining an the firm. “There is an alignment investment bank. “The greatest thing of incentives between managers I ever did was leave and investors in the big business alternatives,” says Any investor that world and move Funk. “Any investor puts capital in a to a boutique,” that puts capital in says Funk. “There a hedge fund where hedge fund where is not a number staff do not have staff does not have money invested in it imaginable that would get me to go money invested in it is crazy. Prop desks back to a BigCo. I at banks, on the is crazy. still deal a lot with other hand, go long investment banks and with other people’s prime brokers. Whenever I walk money, and many will have an implicit through the trading floors and see guarantee by the government. The all of those people sat in front of moral hazard at investment banks is their computers and Bloomberg insane, as it incentivises short-term terminals, it looks soul-destroying.” gains at the expense of long-term Not only does he not have to engage stability. If a bank is too highly in corporate politics, he also finds levered and incurs big losses, the the work far more rewarding than government and taxpayers will bail anything he did in investment them out. That would never happen banking. “I like to get my hands dirty at a hedge fund. There is a lot more in different places,” explains Funk. pressure in a boutique, as the buck “At a boutique organisation, it is stops with you.”

COO

57

COOs DISCUSS THE PRACTICALITIES OF SWAP CLEARING WITH CCPs London, 29 March 2012 Knowledge Transfer Network

Roundtable

Financial Services

COOConnect brought together a group of members active in the OTC derivative markets with leaders of each of the four main CCPs developing swap clearing services. COOConnect gratefully acknowledges the sponsorship of this discussion by CME Clearing Europe, Eurex Clearing, ICE Clear Europe and SwapClear, the swap clearing service from LCH.Clearnet. We present here a summary of the key points raised in the discussion. Visit www.cooconnect.com to view the video, read the transcript or listen to the MP3.

Timing. Implementation schedules remain uncertain, and subject to change as regulators scramble to keep up with political agendas, though the US (Dodd Frank is now law) is ahead of Europe (EMIR has yet to become law, but rules are expected to be published by the end of 2012 and clearing to become mandatory in 2013). There is pressure to appoint a clearing broker now, because onboarding is time-consuming, and demand for clearing brokers might exceed supply. There are only 15 clearing brokers vying for business, and one participant says it took seven months to transition a single fund. Larger funds are also advised to appoint a minimum of two clearing brokers. Worries about lack of broker capacity are why prime brokers are already clearing swaps for hedge funds on a voluntary basis. There is an expectation smaller funds will end up without a clearing broker. There is a case for bigger hedge funds being allowed to go direct to the CCPs, though it would place a strain on technology and staff budgets and capital resources.

58

COO

Costs. Funds are not eager to spend money on new technology and learning-on-the-job lawyers to negotiate clearing agreements with brokers while the final rules are still uncertain, but may be penalised if they do not have a clearing broker in place when swap clearing starts in earnest. Once clearing starts, there will be clearing fees to pay, and costly eligible collateral to source. Non-cleared business will become more expensive, because capital consumption will be higher and margin calls larger. There is less scope to re-hypothecate collateral in the US than Europe, which will further add to costs charged by clearing brokers. There is also lack of clarity on the scope to cross margin: if it is limited or forbidden, collateral costs for hedge funds will rise further. Funds short of eligible collateral will incur the additional cost of collateral transformation trades. Costs may be high enough to drive smaller funds out of the swaps business. One solution is for bigger firms to help smaller firms adapt, or for the industry to develop a utility to service hedge funds of all sizes. The good news is that a rising appetite for

Operationally Commingled (LSOC) collateral arrangements has failed to reassure funds in the wake of the MF Global failure. EMIR currently offers users a choice of individual or pooled segregation of collateral. Hedge funds remain unclear whether their collateral is exposed to their clearing broker or the CCP, and struggle to understand the risk “waterfalls”— membership criteria, initial margin, variation margin, guarantee funds and risk management methodologies—at different CCPs. This is limiting understanding of their exposure in the event of CCP failure. Hedge funds using swaps inside a UCITS structure may also find the concentration of business at CCPs leads to inadvertent breaches of counterparty limits.

Date: March 29 2012, London Moderator: Dominic Hobson, Founder, COOConnect Panellists: Anthony Belchambers, CEO, Futures and Options Association; Lee Betsill, COO, CME Clearing Europe; James Coltman, COO, Arrowgrass Capital Partners; Michael Hieb, chief risk officer, Cairn Capital; Alison King, SVP, Eurex Clearing; Alistair Milne, professor of finance, Loughborough University School of Business and Economics; Stephen Plestis, director, listed derivatives and OTC clearing, Credit Suisse Prime Services; Gareth Roblin, head of fixed income operations, Avoca Capital; Jaki Walsh, group derivatives operational officer, F&C Asset Management; and Mark Woodward, head of corporate development, ICEClear Europe.

COO

59

Roundtable

CCP-eligible collateral will give funds bargaining power with clearing brokers.

Operations. Despite the efforts of regulators to co-ordinate clearing rules, there will be differences between clearing regimes in the US and Europe. Hedge funds familiar with ISDA documentation are still unclear what swap documentation will be like. Most hedge funds are happy with a single futures clearer, but will need several to clear different swaps at different CCPs, and cut counterparty credit risk.

The downside is the operational complexity of porting positions, especially if a CCP fails. There is concern about the scope for hedge funds to segregate collateral held at CCPs, particularly in the US, where the concept of Legally Separate

COO Q&A

MANAGED ACCOUNTS FOR START-UPS In January 2012, it was announced that Deutsche Bank and Financial Risk Management (FRM), the $9 billion fund of hedge funds, now part of Man GLG, had joined forces to launch a hedge fund seeding managed account platform dubbed the dbalternatives Discovery Platform. The idea is to combine the power and experience of the Deutsche Bank managed accounts platform with the seeding expertise of FRM. COO asked Patric de Gentile Williams, chief operating officer of FRM Capital Advisors (FCA), what benefits emerging managers can expect to gain from the venture.

60

COO

Why do you think managed accounts for start-ups will attract investors and managers?

Historically, managed accounts were focused on the largest managers. If one looks at the stable of managers on these platforms, they tend to be the likes of Brevan Howard, BlueCrest or Paulson.

The platforms were rarely, if ever, focused on start-ups. When thinking about the advantages of managed accounts, they offer better corporate governance, enhanced operational infrastructure and independent risk management—all of which is incredibly valuable for smaller managers.

What persuaded you to work with Deutsche Bank?

It was a natural fit. Deutsche Bank was looking to extend its platform

COO Q&A

to emerging managers, and investors which use managed accounts were asking for access to a broader range of managers, and opportunities to invest in emerging managers via managed accounts.

How will FRM work with Deutsche Bank?

With our experience in seeding, we select and negotiate strategic investments in emerging managers, which will be made through the dbalternatives Discovery Platform.

Deutsche Bank will raise capital for a seeding fund, which will be allocated to the hedge funds selected by us, predominantly through managed accounts set up with the manager on the platform. It is hoped over time that the successful funds will migrate onto the flagship dbalternatives platform. In our agreement, FRM are responsible for the sourcing of opportunities, manager evaluation and selection, as well as deal negotiation and operational due diligence.

How many investments do you expect to make in an average year?

We anticipate we will receive on average anywhere between 500 and 1,000 proposals from prospective funds each year, and we hope to make between four and seven

investments per year, which is a success rate of less than 1 per cent. It is a very thorough selection process.

Deutsche Bank does have a veto on our suggestions, which might be deployed if the fund does not fit on their managed account platform.

However, it is important to bear in mind that investors will also be able to allocate directly into managers on the platform.

What minimum size, strategy, asset class and operational infrastructural criteria are you setting?

There are no minimum assets under management (AuM) requirements.

We are perfectly happy to be the first and only investor into a fund, with the exception of the manager’s own capital. We are not wholly strategydriven either. We are more concerned with the over-arching quality of the investment proposition. That said, we are in the hedge fund business and we would not look kindly on a manager investing in highly illiquid products, or pursuing a directional strategy with a sustained beta correlation to major asset classes.

We want genuine alpha generators.

Furthermore, most hedge fund startups have around $100 million. We would like managers to grow, so we cannot invest with managers which are unable to manage significant COO

61

COO Q&A

amounts of capital. In terms of operational infrastructure, we are not that concerned about it when we first meet a manager, but we are very concerned about it the day we write our first cheque to the manager.

We are more than happy to help managers and give them guidance, coaching and introductions to enable them to build a best practice infrastructure.

We are having this conversation in five years’ time. How will you measure success?

The platform will be a success if it has allocated north of $500 million.

If it has allocated more than $1 billion, that would be fantastic.

While we do not have a precise target number for seed deals, I suspect we will make two to three deals this year and, by 2013, anywhere between four and eight deals. However, it is still very early days.

Research by Moody’s Investor Services in 2010 found managed account uptake by investors was slow.

What makes you optimistic?

The research by Moody’s was conducted not that long after the crisis ended. I believe more recent research would show an uptake trend firmly in place. Establishing managed accounts entails a lot 62

COO

of negotiation and re-structuring to ensure a hedge fund fits on a platform—and that is not a quick process. It takes around two months to set up a managed account, even after all the terms and conditions are set. While they remain a small percentage of overall hedge fund AuM, assets are increasingly flowing into managed accounts.

The Deutsche Bank platform has experienced strong growth in recent years.

A seeding managed account platform is nevertheless a new concept. Do you expect imitators?

Yes. Seeding via managed account platforms was not possible until recently, because managed accounts were not geared to work with emerging managers. So this is a very new and exciting proposition, but I believe it will gain traction with investors, and particularly with the sovereign wealth and pension funds which are keen users of managed accounts already. The platform will also give new managers ready access to institutional standard infrastructure, which is a compelling proposition for day two investors.

I would be surprised if the other platforms out there were not thinking about developing their own seeding managed account vehicles.

LD R

PR

IM

E BR

E

R

FITZ G A ER

CANT O

COO Q&A

K O

It was at the nadir of the immediate post-crisis marketplace in 2009 that Cantor Fitzgerald made the bold decision to enter the prime brokerage arena. Its logic, reinforced if anything by the treatment of small hedge funds by big prime brokers during the heat of the crisis, was that midtier hedge funds were being under-served by the major investment banks. Three years on, Cantor Fitzgerald is not only still in the business, but growing. COO asked Noel Kimmel, global head of Cantor Fitzgerald Prime Services, about the strategy the firm is now pursuing.

64

COO

COO Q&A

Tell us why you decided to enter what was already a crowded prime brokerage market. What did you have to offer hedge funds?

Our focus has always been to provide a higher touch client service model, as we believe that mid-tier hedge funds, which have assets of between $25 million and $750 million, do not receive full benefits and resources from a bulge bracket firm. We offer traditional, full service equity and fixed income prime brokerage capabilities to hedge funds and other money managers, which includes clearing, financing, execution, futures and securities lending services.

Can you give us an overview of the size and nature of your hedge fund clients?

Currently, we have approximately 150 clients, and we are continuing to grow our client base. We do not have a fixed target in terms of how many clients we would like to service. Rather, we focus our business on working with the right clients. We are more diverse than most prime brokers in the mid-tier space, and work with a broad array of hedge fund strategies including long/

short equity, event-driven, fixed income, convertibles, credit, mortgage, macro and commodity trading advisers (CTAs). Being diverse allows us to remain nimble in this market and prevents us from being dependent on any one strategy. In terms of geography, our operations are mainly in the United States, but we have plans to move into Europe and Asia.

How developed are those plans to develop a presence in Europe and Asia, and what attracts you about those markets?

In Europe and Asia, the midmarket hedge fund space is underserved by the investment banks in much the same way it had been in the United States. We see that many mid-tier managers often get lost working with larger prime brokers. We are looking to market ourselves to mid-sized managers as a primary or secondary prime broker. We also hope to get some larger hedge funds that are multi-priming who can utilise us as a complement to their other providers. As a response to current market conditions, most managers, as well as their underlying investors, have increased their

COO

65

COO Q&A

scrutiny around counterparty safety. This has caused many managers, who had not previously done so, to multi-prime, and Cantor Prime has benefited from that demand from our clients.

There is a view that the mid-tier sector of the industry is unlikely to thrive, and many smaller providers have struggled to build a business.

Why should the Cantor experience be any different?

The biggest challenge for any new entrant is getting its name out there. Cantor Prime Services has a large and distinctive advantage as we are able to leverage the brand recognition of Cantor Fitzgerald and its platform, including its global sales force and infrastructure. Throughout 2009, there were several new entrants into the market that struggled as they established one dimensional businesses, such as specialising in long/short equity strategies. Their models were overly reliant on steady equity trading volumes and strong performance in the equity space. We have a multi-asset class model which offers equity, fixed income and futures, and which does not rely solely on execution or DMA revenues to drive our business.

66

COO

Even some of the brand-name prime brokers came under pressure after the collapse of MF Global, with their funding models in particular coming under close scrutiny. Does that worry you?

We are a distribution-focused investment firm and we do not participate in proprietary trading.

Cantor Fitzgerald facilitates trades on behalf of our clients. In this environment, we see more clients re-examining counterparty risk in order to better understand the nature of the safety and security of their assets at executing or trading counterparties. With the fallout from MF Global, we were able to secure several large clients, and have access to a larger and higher calibre talent pool.

Cantor Fitzgerald has plans to launch a seeding business. Which of your clients can expect to benefit?

This is part of our overall focus on providing services that cater to middle market hedge fund clients by helping emerging managers find day-one capital. We intend to allocate to those managers with a strong pedigree, investment prowess and solid infrastructure and which are able to meet our strict operational due diligence requirements.

BEE

all you can

BEE

MyCOOConnect is a social network business platform for COOs in the fund management industry.

If you would like to know more, call Anita Craw on + 44 (0) 7557 301 812 or e-mail anita.craw@cooconnect.com

www.cooconnect.com Expert Panels | Peer2Peer Chat | Find a Non-Exec Director | Magazine | Webinars | Benchmarking |RFPs | Events Group Networking | Find a Charity | Browse the Library | Surveys | Polls

COO

67

COO Feature

A Big T Cold Country with a

Small Hot Market Despite not many not large managers running not a lot of money, Canada supports six indigenous prime brokers and a bevy of hedge fund administrators. What are they all doing?

68

COO

he Canadian hedge fund industry is not the largest in the world.

The Toronto branch of the Alternative Investment Management Association (AIMA) reckons Canadian managers run just $30 billion, or less than a sixtieth of the $2 trillion-plus managed by the global hedge fund industry.

Canadian investment strategies, being rooted in the mining, oil, gas stand other natural resources stocks that make up four fifths of the market capitalisation of the Toronto Stock Exchange (TSX), have also tended to lack differentiation.

“Long/short equity is the dominant strategy in Canada,” says Robert Lemon, managing director and head of prime brokerage at NBF Financial Markets in Toronto. “We have a lot of managers focused on oil, gas, mining and pulp and paper,” adds Brad Taylor, global product manager for investment finance, market products and services at RBC Investor Services. But Thomas Kalafatis, head of prime brokerage at CIBC World Markets, believes Canadian hedge funds are now evolving. “A lot of the strategies being employed by Canadian managers are similar to their global competitors,” he says. “It is not just long/short equityfocused. We also see a lot of merger arbitrage and event-driven managers, quantitative traders and high-frequency traders entering the market.” CIBC is certainly growing fast in its domestic market, chiefly because it has focused

COO

69

COO Feature

on servicing high frequency, quantitative director of the RBC Capital Markets traders that used to work at investment prime brokerage business, agrees that banks.

Canadian funds are increasingly But if the Canadian industry attractive to institutional money. is becoming a microcosm of “We see funds launching the global industry, the funds with $10 million and $20 are certainly more micro than million, which is quickly cosmic. Bar the $9 billion growing into $200 million,” multi-strategy Sprott Asset he says. “Funds which have Management, impressive launched recently are in a size and instant brand much stronger position recognition are not the than their equivalents obvious characteristics were seven or eight Thomas Kalafatis, of Canadian managers. years ago. They have Head of prime brokerage at “There are a handful of improved risk management CIBC World Markets billion dollar shops out there, and compliance, and some of which have gone hard are attractive to institutional close,” says Gary Ostoich, chairman of investors globally.”

AIMA Canada and president of Spartan Brad Taylor says much of the Fund Management, a Toronto-based institutional interest is coming from multi-strategy hedge fund manager. “I outside Canada. “The Canadian estimate the average hedge fund is about hedge fund market is seeing a lot of $100 million although I suspect the non-Canadian institutional investor median is much lower. There are a lot interest,” he says. “We are seeing a of managers with south of $50 million.” lot of allocators in Europe and the Nevertheless, prime brokers argue that United States express an interest in Canadian managers are developing our managers.” The highest profile the operational infrastructure which international allocation to a Canadian enables them to attract allocations from manager was the $100 million placed institutional investors as well as their with Breton Hill Capital by CalPERS, traditional clientele of high net worth the $223 billion Californian pension investors. “Historically, the largest fund. It helped that the Toronto-based buyers of Canadian hedge funds were manager is running a global macro fund, domestic high-net worth individuals, in a year when there was more demand but this is changing rapidly,” says than supply for macro strategies, but Taylor. Andrew Thornhill, managing the investment certainly highlighted 70

COO

Your Strong, Canadian Counterparty

When you are looking at Canadian opportunities, speak to us. As the top-ranked Canadian multi-prime in Global Custodian’s 2011 Prime Brokerage Survey1 and as the second-largest borrower of Canadian equities globally2, CIBC deserves a careful look when you are choosing a prime brokerage partner.

We have the talent, technology and capital strength – for what matters.

www.cibc.ca/primeservicesgroup 2011 Global Custodian Prime Brokerage Survey. 2 Data Explorers Q4, 2011.

Services provided by CIBC World Markets Inc., a wholly-owned subsidiary of Canadian Imperial Bank of Commerce and part of Canadian Imperial Bank of Commerce’s wholesale banking arm which also includes other affiliates including: CIBC World Markets Corp., CIBC World Markets plc, CIBC World Markets Securities Ireland Limited, CIBC Australia Ltd, and CIBC World Markets (Japan) Inc.,: “CIBC” refers to the CIBC group of companies. CIBC World Markets Inc. is a member of the Investment Industry Regulatory Organization of Canada and the Canadian Investor Protection Fund.

1

COO Feature

the comparative disdain of domestic institutions towards domestic hedge funds. “The big institutional pension funds in the country are increasingly investing in hedge funds although they tend not to be Canadian managers,” says Steve Banquier, vice president and director of prime brokerage at TD Securities. “More often than not, the pension funds opt for global names out of New York and London.” But Andrew Thornhill reckons this playit-safe attitude is changing. “Domestic pension funds invest in domestic managers whenever possible, but one of the issues holding them back was the [risk that the] pension fund would become a significant investor relative to the size of the fund,” he says. “This is now changing as funds are larger and we are seeing more domestic pension funds invest in Canadian managers.” Others say investors find Canadian regulation— local hedge fund managers face the same compliance requirements as mutual fund managers—reassuring. “Managers must have adequate academic credits to manage money,” adds Ostoich.

“While some of the requirements can be a barrier to entry, it does help to reassure investors.” Rob Lemon adds that “the Canadian regulator offers good oversight and is engaged. The Canadian marketplace is well regulated and managers are required to be subject to thorough oversight.”

72

COO

Performance still matters more than regulation, even to institutional investors. But, as elsewhere, institutional allocations are rising in spite of average performance rather than because of it. Canadian hedge funds did not distinguish themselves last year, with the Scotia Capital Canadian Hedge Fund Performance Index dropping 9.2 per cent on an equal-weighted basis. This was slightly better than the Dow Jones global index in 2011, but marginally worse than the S&P TSX Composite Index, which was down 8.7 per cent. But last year was not a vintage one for the average hedge fund anywhere, and local promoters argue that longer term performance will be transformed by the wave of talent now washing through the Canadian hedge fund industry as investment banks shed proprietary trading operations and long-only managers diversify their strategies to incorporate short-selling, leverage and derivatives. “The rationalisation and whittling down of investment bank trading teams means a lot of talented individuals are looking for new careers, and alternatives is going to be one of their first ports of call,” says Michael Newallo, managing director for equity structured products at NBF Capital Markets. This talent, coinciding with increased institutional interest, is what fuels the optimism of the local

Your Canadian Prime Brokerage Solution National Bank Of Canada Financial Markets’ Prime Services is more than a traditional custodian and prime broker. Our comprehensive approach and integrated platform support both managed accounts and pooled funds.

As a single point-of-contact, we leverage expertise across the Bank and deliver all the tools and resources necessary to optimize your investment performance.

CLIENT INSPIRED. PERFORMANCE DRIVEN. PRIME SERVICES: PRIME BROKERAGE . ELECTRONIC TRADING SERVICES . SECURITIES FINANCE . DERIVATIVES . CAPITAL RAISING

Mike Newallo 416-869-8017 michael.newallo@nbf.ca

Rob Lemon 416-869-8507 robert.lemon@nbf.ca

NBF.CA

National Bank of Canada Financial Markets is a trademark of National Bank of Canada used under licence.

COO Feature

chairman of AIMA. “We have seen how to contain a crisis largely of their significant growth in the hedge fund own making: short-selling restrictions. industry post-2008,” says Gary Ostoich. In September 2008 the Ontario “Prior to the crisis, our industry Securities Commission— had about $15 billion in assets the body in charge of under management (AuM) regulating the Toronto although AIMA Canada Stock Exchange—imposed reckons it is now closer to $30 a temporary short-selling billion excluding funds of hedge ban on certain securities funds. I do not see why issued by financial Canadian hedge funds’ services companies.

AuM cannot double A working group of again within five years.” the Canadian Securities Gary Ostoich, That doubling since Administrators (CSA) Chairman of AIMA Canada and president of 2008 took place, however, and the Investment Spartan Fund Management during a period of strong Industry Regulatory interest in what the natural resourceOrganisation of Canada (IIROC) based Canadian economy as a whole are currently engaged in a public had to offer, and in which the relative consultation and review of short conservatism of Canadian investment selling and failed trades. Its reports banks and hedge fund managers allude to “manipulative activity” and provided a welcome contrast with what “disorderly markets,” and IIROC has had happened elsewhere. “During since October 2008 retained (a so the crisis, Canada fared well and far unused) power to designate any was viewed as a safe market to be security as “short sale ineligible.” in,” explains Ostoich. “Hedge funds, Though the working group is not provided they were not leveraged to proposing to force fund managers the hilt, escaped much of the chaos, to disclose short positions, its most as did the banks and financial sector recent public notice promises more generally. The economy is run in a transparency into shorting and conservative way and we have access trade fails, including twice monthly to a lot of resources like energy and summaries of aggregate short metals, which is why people like us.” positions in particular securities. As On the other hand, even Canada it happens, the TSX already publishes was not immune to the chief symptom (as a data product) the 20 largest short of authorities bereft of ideas about positions and the 20 largest changes 74

COO

PRIME BROKERAGE EXPERTISE. The RBC Capital Markets Prime Brokerage platform represents a team of industry experts who offer alternative investment managers the infrastructure, resources and operational expertise to support all of their business initiatives. Our comprehensive Canadian platform is positioned to capture opportunities at all stages of the alternative investment life cycle.

Client Service | Securities Lending | Custody | Clearing | Technology | Financing Take Confidence in Our Approach Andrew Thornhill Managing Director 416.842.6440 andrew.thornhill@rbccm.com

rbccm.com This advertisement is for informational purposes only. RBC Capital Markets is a registered trademark of Royal Bank of Canada. RBC Capital Markets is the global brand name for the capital markets business of Royal Bank of Canada and its affiliates, including RBC Capital Markets, LLC (member FINRA, NYSE and SIPC); RBC Dominion Securities Inc. (member IIROC and CIPF) and RBC Europe Limited (authorized and regulated by FSA). Ž Registered trademark of Royal Bank of Canada. Used under license. Š Copyright 2012. All rights reserved.

COO Feature

in short positions in listed stocks, but the working group is concerned these reports are limited to listed stocks and TSX members.

Although the working group is keeping a close watch on policy developments on short selling in the United States and Europe, and of the work of the IOSCO task force on the subject, Ostoich is confident that Canada—which is not short of regulators, since they recur at the provincial level—has learned what Europeans have not: that short selling is essential to the maintenance of liquidity.

“There has been a lot of research indicating short-selling restrictions do not work and I am hopeful the regulators have taken this on board,” he says. “Unfortunately, some of the restrictions that are in place in parts of Europe have hurt some of our hedge funds.” Rob Lemon is unequivocal on this issue. “I believe regulators have learned their lesson that short-selling restrictions are counterintuitive,” he says. “I doubt Canada’s regulators will impose short-selling restrictions [again] like they did in 2008.”

Intuitive regulation, as it were, is one of the benefits of a less leveraged and less volatile market environment.

The downside is that, rather than put their creditworthiness or reputation at risk, a number of Canadian prime brokers drastically scaled back their 76

COO

commitment to the local hedge fund industry in the 2008-09 period, showing the door even to longstanding clients their senior management was no longer prepared to support. Two years on, they are all back in the business. Indeed, for a small market, Canada is generously endowed with prime brokers. BMO Capital Markets, CIBC, National Bank Financial, RBC Capital Markets, Scotia Capital and TD Securities are all in the prime brokerage business to a greater of lesser extent. TD and CIBC dominate the local marketplace.

TD focuses on domestic managers and Canadian portfolios, while CIBC has carved out a niche servicing the high frequency trading funds spawned by the withdrawal of Canadian investment banks from proprietary trading. It is Scotia Capital which is pursuing the most ambitious international strategy, with operations in London, New York and Singapore as well as Toronto. RBC, whose 2006 acquisition of New York brokerage Carlin Financial once hinted at similar international ambitions, has since adopted a more focused strategy.

National Bank Financial, which also trimmed its more expansive ambitions in 2007-09, still has a huge clearing franchise on which to build. BMO, which acquired a team from Paloma Securities in 2009, has developed a reputation for helping smaller funds with capital introductions.

Sign UP

Sign

L

in

K

Around....

chat to

the LOCALS

MyCOOConnect is a social network business platform for COOs in the fund management industry.

If you would like to know more, call Anita Craw on + 44 (0) 7557 301 812 or e-mail anita.craw@cooconnect.com

www.cooconnect.com Expert Panels | Peer2Peer Chat | Find a Non-Exec Director | Magazine | Webinars | Benchmarking |RFPs | Events Group Networking | Find a Charity | Browse the Library | Surveys | Polls

COO Feature

Yet virtually all Canadian prime brokers found in 2008-09 that their own strategies were much less important in acquiring clients, especially from south of the border, than their strong balance sheets and the strict asset segregation rules of the Canadian regulatory regime.

“Canadian dealers are required to monitor for segregation deficiencies on a daily basis,” explains Banquier. Failure to remedy any deficiencies quickly would need to be reported and sanctions could follow. As the 2008-09 crisis receded into memory, undermining the argument for appointing non-American and conservatively managed prime brokers, the Eurozone crisis created an equally compelling case for prime brokers that were non-European. “Our banking system is not enduring the stresses the banks in the US and Europe are, which is making us an attractive option,” says Lemon. Ostoich agrees.

“Some banks in the United States are recording figures similar to 2008, while some of Europe’s banks appear to be in deep trouble.”

At least one Canadian bank was of course associated with those troubles.

Though the travails of RBC Dexia are not linked directly to the fortunes of RBC Capital Markets, the investment arm has faced questions from clients and potential clients about the securities services arm of the group. What RBC would do about the 50:50 joint 78

COO

venture in securities services and fund administration had rumbled away in the Canadian and foreign press since the failure of its Low Countries partner in the crisis left it as the only buyer of the other half of the JV from a seller which could more or less name its price. The deal was finally completed this Spring.

The publicity was unhelpful, but RBC Capital Markets says it managed client concerns successfully. “We communicate closely with our clients and we are transparent about everything,” says Brad Taylor. “We emphasise that client assets are secure and because of this, we have not lost clients.”

The slow resolution of the RBC Dexia impasse overshadowed the fact that Canada has quietly emerged as something of a haven for hedge fund administrators. Butterfield Fulcrum, CACEIS, Citco, Citi, Goldman Sachs, Maples Fund Services, State Street and UBS are among the hedge fund administrators which have found Canada a useful source of accountants to support their global operations.

Halifax, Nova Scotia has even taken to portraying itself as the North American equivalent of Dublin or Luxembourg: a regional centre for middle and back office operations in the funds industry.

“We are seeing some of the world’s biggest hedge fund administrators, such as Citco and Butterfield Fulcrum, establish offices in Nova Scotia,” says

COO Feature

J.P. Robicheau, director of financial services and nearshore solutions and investment attraction at Nova Scotia Business Inc. “There are a lot of quality companies and providers out there for hedge funds.” Indeed, in terms of its ultimate weight, Canada is likelier to become an in-sourcing location for the operational end of the global hedge fund industry than a truly

large, distinctive and innovative hedge fund management marketplace of its own. Thomas Kalafatis begs to differ.

“We have clout and we are home to a number of large cap companies,” he says. “We face similar challenges to the rest of world in terms of economic headwinds but as a hedge fund market, we have matured, and we will continue to do so.”

CANADIANA: 13 facts for 13 provinces 1. Canadian geology is full of stuff the world wants to buy 2. Canadian hedge fund managers are running c. $30 billion in AuM 3. Ex-prop traders are refreshing the Canadian talent pool 4. Equity long/short is not the only strategy on offer any more 5. High net worth investors are giving way to institutions, mostly from abroad 6. Institutions like the asset segregation rules 7. Managers like the Canadian (creditworthy) primes 8. There is one prime for every $5 billion in AuM in Canada 9. Each Canadian prime has a strategy all of its own 10. Some primes have blown cold as well as hot, but all are still in the business 11. Expect copycat insistence on short-selling disclosure 12. Canada has fund accountants to spare 13. Halifax, Nova Scotia is the Dublin of the Americas COO

79

COO Interview

The More He Practises,

The Luckier He Gets Amid acres of mediocrity, the returns at 36 South read like cricket scores.

COO found Jerry Haworth pleasantly surprised by success.

80

COO

“

If it would not look too much like showing off, I would tell the reader where New Zealand is,” Mark Twain once mused. The land of the long white cloud may be a spectacular film set (the Lord of the Rings trilogy was filmed there) and the birthplace of a film star (Russell Crowe) but even winning the 2011 rugby union World Cup could not infuse New Zealand with glamour.

That is just how fund manager Jerry Haworth likes it. “New Zealand is quiet and it is a country where you can have time to think about things,” says the co-founder of 36 South, a Londonbased manager of macro, volatility, tail risk, inflation and gold funds. “Cities like London have a great buzz and you meet amazing people, but if you want to think by yourself and enjoy a quiet life, New Zealand is definitely the place to be.”

In 2008, when dozens of investment strategies imploded, the quiet

COO Interview

thoughtfulness of Jerry Haworth and his co-founder Richard Hollington ensured that their Black Swan extreme event risk fund delivered a 96.3 per cent annualised return over its short 1.4 year life to closure in May 2009. “We bought long-dated options at the right time and we sat on them on behalf of investors,” explains Haworth. “It was about finding the right opportunities and knowing when to exit them.” But it was as he exited those investments in 2008 that Haworth learned about the limitations of running a fund from New Zealand. “Warren Buffet once said that if a manager makes returns, people will find that manager at the bottom of the river,” says Haworth. “That is not true.

We made huge returns but we did not attract money in New Zealand.”

It was hard to attract money from outside the country too. “It is impossible to raise money out of New Zealand as it is so far away,” explains Haworth. “Many clients told us they liked our strategy but refused to invest as due diligence teams did not want to make annual trips to New Zealand.

Basically, we had to go to London or a financial centre to attract investor capital.” March 2009, the nadir of that stage of the crisis, was certainly an interesting time for a Kiwi hedge fund to be opening for business in London. “When we moved to London, the atmosphere there was almost like,

‘Will the last person to leave London, turn out the lights please?’” recalls Haworth. “We knocked on a lot of doors to get people interested in what we were offering.”

In the end, 36 South set up a bespoke fund for a single investor.

Called the Black Orlov Fund, it pursues a similar strategy to the Black Swan fund, buying long-dated options in the global currency, equity, fixed income and commodity markets in the belief that cataclysmic events will boost their value dramatically. 2011 certainly saw plenty of volatility-inducing events—a tsunami in Japan, the Arab Spring, and the Greek government debt crisis—that helped the Black Orlov Fund return 101 per cent to its investor. Cumulative returns over the previous two years amounted to 43 per cent by the end of last year. The $30 million that 36 South ran for that single investor in 2009 has now increased more than ten-fold, to $415 million across an inflation fund (Cullinan Fund) and two macro funds (Kohinoor Core and Kohinoor Series’ Strategy, which incorporates not only the Black Orlov fund but both US dollar and New Zealand dollar funds dating back over a decade).

Haworth reckons this inflow of capital reflects not the willingness of investors to ignore the correlation between high returns and high risk—the 36 South web site says the Kohinoor COO

81

COO Interview

funds are up by 9.49 and 13.29 per cent respectively on an annualised basis, while the Cullinan fund is down 4.23 per cent on the same basis—but a paradoxical urge to embrace it in such uncertain times as these. “Given the crises that have happened, I think investors will look to volatility and tail risk strategies more for security of assets,” says Haworth. “We pick the right assets and we have done well in bull as well as bear markets. There is nothing to stop us making money in rising markets but it is important to be diversified and not concentrated in one asset class. Tail risk works for both the upside and the downside. It has defined downside risk versus leveraged funds.”

Haworth should certainly know that, having passed almost the whole of his career in the derivatives industry.

Zimbabwe-born, his first proper job after leaving the University of Cape Town with a degree in finance was in the equity derivatives team at Investec, to which he gravitated quickly from less exciting roles in information technology and accounting. “The futures market was brand new when I joined,” says Haworth. “In fact, I was one of the first four people to trade a futures contract in South Africa. We were the first people on the block.”

As he admits, novelty and lack of competing experience made it easier for him to rise quickly, and it was not 82

COO

long before Haworth was made head of the group. “At Investec, we did not really intend to develop the derivatives business but it grew organically,” he says. “It was nice to watch the bank grow like that, and I felt like I was on a winning team.”

In 1996 Haworth formed his own company in Johannesburg. Peregrine Holdings Ltd offered investors a mixture of stock broking, futures and options broking, pension fund structuring and even software services, but the real heart of the business was designing and structuring derivative strategies for institutional clients, usually in the form of a structured note. “I felt there was a niche for structured products as investors wanted institutional structure in derivatives,” explains Haworth.

“One of the problems of working in a bank is that when you pitch to clients a structured product, those clients are often unsure whether you are genuinely trying to offer them a good deal or just wanting to make more money for the bank.” Not being a bank, Peregrine Holdings took off astonishingly quickly, and soon found itself making handsome profits.

“I have fond memories of Peregrine Holdings,” recalls Haworth. “We did so well in the first month that we paid for our set-up costs within ten days.

People were voting with their feet and

COO Interview

giving us business. We hired a lot of good people and the business grew organically. We had a lot of luck on our side too as institutions were getting into structured products more. Furthermore, apartheid had ended, meaning a lot of big international banks were returning to South Africa, which was very good for our businesses.” Peregrine Holdings grew at a startling rate, and in 1998 was listed on the Johannesburg Stock Exchange. The value of the company soared by more than 400 per cent in the aftermath of its IPO. Even Haworth was surprised by the rapidity of the success of Peregrine. “I would not have predicted we would have such success so quickly,” he says. “I certainly did not expect we would have an IPO less than three years after we started. It certainly came about a lot quicker than I imagined.” The pace of success owed something to a rare concatenation of circumstances: the emergence of South Africa from the isolation of apartheid to re-join the world economy, and the launch of a derivatives market in a country with an emerging market industrial and commercial economy, but highly developed and well-regulated financial markets.

For Haworth the success of Peregrine provided the opportunity to start afresh outside South Africa.

It was in 2001 that he re-settled in New Zealand, seeking what he calls a “change of lifestyle.” Setting up a hedge fund was simple then. “New Zealand had lax regulations and it was probably one of the easiest places to set up a business,” recalls Haworth.

“I probably could have set up an investment bank if I had wanted.”

More than ten years have now passed since Haworth set up 36 South—the fund is named after the latitude of Auckland—with Richard Hollington, a former head of gold and precious metals derivatives at First National Bank, using nothing but seed capital from family and friends. But Haworth is still surprised by success.

“I certainly did not start the fund with the aim of developing it into a fully-fledged business with clients worldwide,” he says now. But unlike a great many fund managers and investment bankers, Jerry Haworth of all people should not consider his success a matter of chance, since he has understood that even in a world where Black Swans are regularly encountered, the individual can always improve his luck. Since he has ended up exactly where he wanted to be, that is exactly what he did. “I always wanted to work in finance, right from when I was 14,” says Haworth. “I met a stockbroker once and I just wanted to do what he did. It is all I ever wanted to be.”

COO

83

COO Columns

What Investors want from Form PF A

s dull regulatory abbreviations go, Form PF (Private Fund) is not unusual. But in terms of its potential impact on the hedge fund industry, it is something managers need to understand and act upon quickly. Although it is a small part of the encyclopaedic Dodd-Frank Act, whose 2,000 pages must be the longest essay in extra-territorial jurisdiction ever attempted, Form PF is shaping up to be the most intrusive measure of all.

Its origins lie in the determination of regulators to avoid the embarrassment of 2007-08, when they failed to anticipate one of the greatest systemic financial crises in history. Despite repeated efforts to demonstrate that hedge funds do not and cannot pose a systemic risk, the regulators are determined to collect

84

COO

sufficient data just in case they are.

The largest hedge funds will have to share considerable quantities information with regulators on a regular basis.

At present, hedge funds with more than $1.5 billion in assets under management (AuM) are required to submit an extremely detailed version of Form PF, containing forensic-level information about their operations, to the Securities and Exchange Commission (SEC) by December 2012, and within 60 days of each quarter-end thereafter. Managers with more than $5 billion in AuM have to start their submissions even earlier, from June 2012.

Smaller funds do not escape Form PF altogether. Those with between $150 million and $1.5 billion in AuM must deliver a less detailed

COO Columns

version of Form PF on an annual basis. The lower AuM threshold for Form PF reporting matches the SEC registration cut-off point laid down in the Dodd-Frank Act. But if registration with the SEC was not a big ask—the Alternative Investment Management Association (AIMA) welcomed the idea—nor is Form PF a breeze.

Under Form PF, hedge funds will have to report investment strategies; exposure by asset class and counterparty risk; leverage; geographical concentration; details of their investors; the liquidity of their portfolios; and even turnover by asset class. They will have to report the results of stress tests and Value at Risk (VaR) calculations. The SEC will then hand this information to the Financial Stability Oversight Council (FSOC), the body created under Dodd-Frank to monitor systemic risk.

If this sounds onerous, it is important to remember that the timetable is a lot less demanding than initially proposed. The original proposals applied to managers with more than $1 billion in assets only, but demanded the data be supplied within 15 days of a quarterend, starting from January 2012.

Fortunately, market participants and lobbyists convinced legislators the timetable was unworkable. But

the extra time is no excuse for a complacent approach to compliance.

Managers must tackle the Form PF reporting requirements now, and not wait until the last minute. They need to build an internal and external infrastructure to consolidate the data required to submit reports in a timely and accurate fashion. With an estimated 500 data points to be consolidated, identifying the sources of the relevant data, let alone building the infrastructure to deliver it to regulators, will inevitably take time.

Managers must also be careful to let the SEC know what their regulatory AuM actually is. This is not a straightforward addition of the value of the assets in each portfolio.

Managers must disclose their gross AuM—a definition which includes inflation through leverage. A fund far below $1.5 billion in net AuM, for example, might still be sufficiently leveraged to pass the $1.5 billion threshold that necessitates quarterly submission of Form PF. Smaller firms with limited resources will be heavily impacted, even though they are required to submit Form PF on an annual basis only. Unlike larger firms, which can form a committee of senior personnel to manage the reporting requirements, smaller funds need urgently to put an individual in charge of collecting COO

85

COO Columns

and consolidating the data. That individual is ideally the chief executive officer, chief operating officer, chief financial officer or chief compliance officer.

Help may be available from service providers. Several fund administrators are offering services designed to help funds cope with Form PF compliance. Technology vendors offering data warehouses can also help hedge funds upgrade their technology infrastructure. There may even be longer term benefits.

Since managers ultimately bear responsibility for the quality of the data they submit to regulators via Form PF, delegating total responsibility to a fund administrator or vendor is ill-advised. Managers must maintain close involvement in the data-gathering and reporting process. That is also why, regardless of size, hedge funds must insist that the operation is automated rather than manual. Only automation will ensure the data they report is both accurate and up-to-date.

That data will of course be of interest to investors. One of the more contentious aspects of Form PF is

whether they should be allowed to see it. Personally, I believe investors should never be shy about asking for anything. But my inner cynic suspects that managers will not be inclined to share the Form PF data with their investors. Their compliance officers will also be uncomfortable about authorising the disclosure of the data to investors.

Managers understandably fear sophisticated investors will copycat their trades. Theoretically, a shrewd investor could reverse-engineer trades, but the risk is small. The data managers supply to regulators through Form PF will be at least 60 days old. The likeliest outcome is that managers will provide investors with a summary of the Form PF data, similar to the Internal Capital Adequacy Assessment Process (ICAAP) pillar 1 and 2 summary reports they share already.

Pierre-Emmanuel Crama is head of ODD at Signet Group.

He is writing in a personal capacity and the views expressed here do not represent the views of the Signet Group, its employees, partners or any of its affiliates.

86

COO

New needs call for new approaches.

A new generation of global prime brokerage.

At J.P. Morgan, we meet our clients’ evolving needs by offering dynamic solutions, a full product suite and the market-leading capabilities of our entire firm. Discover how J.P. Morgan can meet your needs today. jpmorgan.com/primebrokerage

© 2012 JPMorgan Chase & Co. All rights reserved. All product names, company names and logos mentioned herein are trademarks or registered trademarks of JPMorgan Chase & Co. Access to financial products and execution services is offered through J.P. Morgan Securities LLC (“JPMS”) and J.P. Morgan Securities Ltd (“JPMSL”). Clearing and custody services are provided by J.P. Morgan Clearing Corp. (“JPMCC”) and JPMSL. JPMS and JPMCC are separately registered U.S. broker dealer affiliates of JPMorgan Chase & Co. and are each members of FINRA, NYSE and SIPC. JPMSL is authorized and regulated by the FSA and is a member of the LSE. J.P. Morgan Securities (Asia Pacific) Limited is regulated by the HKMA.

COO Feature

HOW TO BE A MAMMAL

AMONG DINOSAURS They say you need $100 million in AuM just to cover the cost of running a hedge fund these days. But these absurdly over-regulated and over-institutionalised days, when it seems that running a management company properly is more important than running money properly, are actually rich in opportunity for new talent.

L

ike it or not, the hedge fund industry similar survey (in 2011) of institutional is succumbing to the 80:20 rule. clients by J.P. Morgan found two out of It could even be a 90:10 rule. All that five investors writing tickets of at least is certain is that the majority of assets $250 million will not even consider a under management (AuM) manager that is below $1 billion are gravitating towards the in AuM. The successful start-up larger funds. Last summer of 2012 is probably running Citi Prime Finance between $500 million and $1 estimated just one manager billion the day it opens in eight controlled the vast for business. Why? majority of the $2 trillion or Because institutional so that is invested in hedge money is sensitive to funds. According to concentrations of risk, Hedge Fund Research, and does not want to find nearly three quarters itself effectively owning Robin Grant, of net capital inflows a fund. Institutions such COO of Nectar Capital in 2011 went to funds as pension funds, sovereign with more than $5 billion in AuM. wealth funds and insurance companies Finding Direction in Uncertain Terrain, (whose appetite for hedge fund risk the Credit Suisse survey of investor is anyway expected to fall once the preferences published this Spring, found Solvency II directive starts to bite) investor appetite doubled once a fund also have high and rising expectations was running at least $100Â million. A in terms of operational controls, 88

COO

COO Feature

compliance and corporate governance. in London. “Historical performance data They know that these are hard for shows that the returns of the majority hedge fund managers to match when of hedge funds will generally be best they are collecting 2 per cent or less on in the first three years of their lifespan. $50 million.

Additionally, although somewhat There are good reasons to question dependent on strategy, smaller funds and the wisdom of this approach, not least their managers can be more nimble in the the difficulty hedge funds encounter market place, quicker to react to market in sustaining performance once assets events and able to participate in smaller clear a certain threshold. The Neuberger markets.”

Berman strategy outlook report says the There is evidence that even the biggest average emerging manager returned 9.49 institutional investors understand this. per cent in 2011, against 7.61 per cent A 2012 J.P. Morgan poll which found for the average established manager. “As big investors shunning sub-$1 billion hedge funds’ AuM get larger, it becomes funds also found 70% respondents more difficult for them to participate in would allocate to a start-up. In fact, the sometimes smaller profitable and niche proportion prepared to allocate to funds investment strategies,” with less than $50 million in AuM is says Tushar Patel, actually higher now The average emerging chief executive of (37 per cent) than manager returned HFIM, an emerging it was in 2009 (25 manager-focused fund per cent). Finding 9.49 per cent in of funds in London.

Direction in 2011, against 7.61 per “Thus, they have to Uncertain Terrain cent for the average end up participating agrees that investor established manager. in larger and often views on size are crowded investment influenced by the prospect opportunities.” Unlike larger hedge funds, that performance declines in line with smaller managers tend to remain focused size. “When assets expand past a certain on pursuing investment opportunities, point, investors apparently begin to give rather than cultivating investors in an consideration to the manager’s ability to effort to keep management fees buoyant. navigate markets in a nimble manner,” “There will always be demand for reads the Credit Suisse survey. “This is smaller funds from some investors,” reflected in the drop in the number of says Robin Grant, COO of Nectar investors for whom AuM is irrelevant Capital, a sub $100 million hedge fund after a fund reaches $2 billion in assets COO

89

COO Feature

from 86 per cent to 70 per cent. There is a more sympathetic. Funds of funds, further drop to 55 per cent when the fund still struggling to justify their existence exceeds $5 billion.” However, there is a after failing the test of the crisis, remain concern that this institutional money is enthusiastic supporters of new talent, not going to genuine start-ups. “There is as do private banks, family offices, a lot of money flowing into sub-$1 billion endowments and foundations and high funds but the money is not finding its net worth individuals. Funds of funds way to day one funds,” says Ron Suber, made up 70 per cent of respondents senior partner and head of global sales to a 2012 Citi Prime Services survey at Merlin Securities, now part of Wells on early stage managers, while private Fargo Securities, in New York. “There banks, endowments and wealth offices are a lot of start-ups with potential who accounted for most of the rest. As a offer investors generous fee concessions result, emerging hedge fund managers and equity stakes.” continue to attract capital, mainly from Certainly the disappointing 2011 traditional investors, albeit in modest returns from some of the larger names amounts. According to the Citi Prime ought to make these times propitious Finance survey, just $5.6 billion went for new talent. “There is a to 352 launch funds in 2011, or significant polarisation between an average of $15.9 million. the newer managers and Those subscriptions took the well-established hedge the total capital invested into funds,” says Athanasios start-up funds to a cumulative Ladopoulos, a partner at $12.4 billion since 2009, or Swiss Investment Managers in a mere 0.6 per cent of total Zurich, and senior portfolio hedge fund AuM today. manager at the Directors It follows that, for Dealings Fund launched institutional investors, Tushar Patel, in September last year. the attraction of higher Chief executive of HFIM “Savvy investors are often returns is offset by the attracted to the ability of problem of attaining scale. newer managers to generate alpha and Some predict that the Volcker Rule, by solid performance. Newer managers, as forcing established proprietary trading they are hungrier for capital, are often teams out of the investment banks, will more eager and have more at stake to provide investors with a more attractive do well.” Those newer managers are combination of talent and size. “There finding traditional hedge fund investors was a wide breadth of firms setting up 90

COO

COO Feature

in 2011 and the quality was excellent,” risk and equity finance personnel. Not says Danny Caplan, European head of having dealt in-depth with this side of alternatives distribution at Deutsche Bank the business before can potentially lead in London. “Regulation has forced many to a sub-optimal set up. This is a risk that prop desks to leave investment banks, and can be mitigated by the engagement of an these new organisations are attractive to experienced and energetic COO.” investors as the individuals have worked COOs are of course one of the costs successfully together before.” But the that eats the management fee. But it story is not as simple as it sounds. Many is hard to see how even a start-up can former prop traders still lack a verifiable escape without one, given the regulatory track record. Investment banks, strange deluge managers are now confronted to report, rarely audit the performance with. Compliance with the Doddof traders over time. “Having short track Frank Act, Securities and Exchange records or lacking any track record, Commission (SEC) registration, the particularly during the stress periods Alternative Investment Fund Managers of 2007 and 2008, can be difficult for Directive (AIFMD) and the Foreign certain investors to consider investing,” Account Tax Compliance Act (FATCA) says Tushar Patel. Nor are all adding to dayis a trading desk the to-day costs. The It does not help to place to learn about aspect of Doddbe an ex-prop trader. the tedious operational Frank causing most Investment banks, aspects of running a concern at present hedge fund. “Leaving strange to report, rarely is Form PF (Private an investment bank Fund), which must be audit the performance or major hedge fund completed annually of traders over time. can lead to a loss of by all hedge funds institutional infrastructure managing between $150 and culture which is a key risk,” adds million and $1.5 billion. It demands Robin Grant. “These managers have in-depth details on investment strategy, been used to having a solid operational counterparty exposures, leverage, infrastructure around them and will geographical concentration and asset generally have not had to allocate any classes in a portfolio. This information intellectual bandwidth to the operational will ostensibly be perused by the side of the business. It will have been Financial Stability Oversight Council, the taken care of by in-house middle and body tasked with monitoring systemic back office staff, legal, compliance, risk in the United States. Populating COO

91

COO Feature

Form PF will devour resources, especially outsource the work to a specialist, who in the first year, when neither managers can amortise the expense over many nor their advisers will be fully acquainted clients. “Outsourcing is a viable option with its requirements. In the case of and can reduce costs, especially in the AIFMD, the cost of appointing a third early life-cycle of a new manager when party custodian could even make running every pound, euro or dollar counts,” regulated fund of the kind some investors adds Grant. “However, it is important prefer prohibitive. that there is solid oversight of the service “Everyone is aware of the everprovider to ensure the on-going quality of hardening regulatory environment,” the service being received.” says Robin Grant. “The full implications A growing number of compliance of AIFMD are not still completely consultancies now offer regulatory understood by the broader market and, compliance services on an outsourced although there are a number of months basis. The IMS Group is one with before any real impact, the uncertainty a hedge fund practice. Hedge fund is diverting the attention of managers. hotels—those symbols of the heroic age There is a real concern the costs of hedge fund investing—are making associated with depositary a comeback. It is even possible custodianship will increase to appoint an outsourced COO, the expense load and who will not work full-time but therefore the performance will have senior management returns of many funds.” experience. While some argue Inevitably, smaller managers this increases risk, it does will feel the pain of regulation save money. “Partnering more keenly. “The cost base with Boris Onefater, for running a hedge fund CEO at Constellation is getting much higher,” Investment Consulting Ron Suber, says Kevin Mirabile, in New York, enables Senior partner and Head professor of finance at us to build the hedge fund of global sales at Merlin Fordham University and more effectively,” says Brian Securities in New York a former COO at Larch Dawson, COO at Wingsail Lane Advisors, a ConnecticutCapital, a soon-to-be launched hedge based fund of funds. “Compliance fund. “We presently leverage his deep with the SEC registration and reporting expertise in finance and compliance requirements will not come cheap.” in the CFO function, allowing us to One way to cut costs of that kind is to develop the business intelligently.” Not 92

COO

COO Feature

everyone is convinced it makes sense.

“Outsourcing certain functions can help manage the cost base,” says Jeremy Siegel, global head of prime consulting at Credit Suisse. “However, outsourcing the CFO or COO role can be a stumbling block for many investors. A vital criterion for an investor conducting due diligence is the quality of the operations and infrastructure, where the CFO or COO can be central. Outsourcing this function may be interpreted as a lack of commitment to the non-investment side of the business.”

Investors are not always unsympathetic to outsourcing. They understand that management functions can take time to grow in-house. What they are much more concerned about is the quality of the counterparties. “Counterparty risk is so important, especially given the volatile markets,” says Kevin Mirabile.

“Administrators and prime brokers must be high quality to secure institutional capital.” Investors still have a weakness for brand-names in prime brokerage— if a bulge bracket name refuses to do business with an emerging manager, it is a signal not to invest—but recognise it is unrealistic to insist on a fund being multiprime from the outset. Credit Suisse, like most of the major prime brokers these days, takes on a lot less business than it sees. The bank aims to work with a select number of emerging managers it believes can succeed through differentiation. “We

actually do not set a minimum AuM, but try to partner with managers whom we believe can be successful in the long-term for their investors, and even more so with our help,” says Jeremy Siegel. Funds that fail to attract the attention of the major prime brokers must make use of mini primes or introducing brokers. They are relatively inexpensive, but their model of business has come under pressure recently, as major banks have terminated their clearing and custody arrangements with them.

This has prompted some closures and consolidation in the sector and some observers—not all of them disinterested—have gone further and openly predicted the demise of the mini-primes. “There has been an oversupply of prime brokers and administrators,” says Ron Suber, whose own firm is now part of Wells Fargo.

“With everything that has happened at MF Global and concerns over the capitalisation of mini primes, it is essential to go with a good name.”

Robin Grant acknowledges that not every new or emerging manager has the luxury of choosing the service providers they would like, but he has concrete advice on which names are better guarantors of long term success.

“For a fund to be as attractive as possible to potential investors, they generally need to get a big four auditor, a top ten administrator and a top five COO

93

COO Feature

prime broker,” he says. “The Nectar an average 62 basis point discount on Global Alpha Fund engages top-tier management fees and an average 502 counter-parties, but a lot of our peers basis point cut in performance fees in may not have access to these firms, as the last year, reducing them to 1.5 per many counterparties can view emerging cent and 15 per cent respectively. The managers as too small, excessively bank says American investors were risky or without a quality track-record. the most aggressive, with nearly two It is important for emerging managers in five demanding a 75 basis point fee to demonstrate to counterparties that concession—more than double the their fund will be successful and will be discounts sought by their counterparts in valuable to them in future years.”

Europe and Asia.

Prime brokers are prepared to For emerging managers, the subsidise in the early years those funds more fluid environment on fees can they believe have a viable future. This be attractive, provided they do not is just as well, since investors are simultaneously make it too easy for putting even larger investors to exit. fund managers “A discount on Do offer discounts under pressure on management fees on management fees. and, potentially, management and Do not relax liquidity performance fees for performance fees.

The traditional 2 and ‘early bird’ investors is terms.

20 fee structure (2 per one way of incentivising cent for management and 20 per cent capital in-flows,” says Robin Grant. of performance) is no longer the norm.

“Although economically painful, fee According to research published last rebates often help to secure early or year by alternative investment industry sizeable investments, which in turn data providers Preqin, the average hedge make it easier to attract further capital fund management fee stands at 1.6 later on at full fees. What a manager per cent, and the average performance must not do is offer more favourable fee is at 19.2 per cent. Hedge Fund liquidity terms or portfolio transparency Research (HFR) says new managers to selected investors. Such preferential secured an average management terms will be detrimental to capital fee of 1.58 per cent and an average raising efforts. Typically, institutional performance fee of 17.04 per cent in investors will not allocate to a manager 2011, which is the lowest figure since where they feel other investors have 2003. Citi reports investors seeking superior terms to redeem from the 94

COO

COO Feature

fund or are better placed to make that redemption decision.” Indeed, it is more sensible for managers to negotiate lower management and performance fees in exchange for tighter liquidity terms and longer lock-ins.

But, however sensible the long term strategy, a combination of reduced fee income and rising regulatory and infrastructure costs is making it harder for smaller managers to get going, let alone survive. “This is a very challenging time for emerging managers,” says Kevin Mirabile. “A lot of smaller funds are finding the higher cost bases unacceptable and are struggling to rely on their incentive fee.

Add in some market volatility, and it can be a deadly combination for some emerging managers.” Ron Suber of Merlin emphasises the need to keep

cost under control. “Fee pressures are mounting so it is essential for managers to keep expenses below a fixed rate,” he says. “There continues to be give and take amongst investors and managers.

Interests are becoming even more aligned. Large investors often demand lower fees and frequently get them. For managers with a stable base of assets and recurring management fee revenue, a lower management fee in exchange for a higher incentive fee based on performance can be tolerable and even favourable.” Certainly one investor says he has no interest in pushing managers excessively on fees. “We would not normally put pressure on managers’ fees,” says Tushar Patel. “The managers need all the fees in the initial stage to develop their business and build a sound operating infrastructure.”

Seven secrets of success for smaller funds 1.

2.

3.

4.

5.

6.

7.

Stay small enough to be nimble Keep costs under control Stick to classic hedge fund investors Retain brand-name prime brokers … … and brand-name administrators Outsource the compliance burden Trade management and performance fees for longer lock-ins COO

95

COO Person

F

rank Meyer is a legendary hedge fund investor and advisor with more than 40 years in the investment industry. During that long career, he and his various business partners seeded or invested at an early stage in many of the most illustrious names in hedge fund investing, including Ken Griffin of Citadel, Steven Cohen of SAC Capital Advisors, Ed Thorp and James Regan of Princeton/Newport Partners, and Bruce Kovner of Caxton Associates. Griffin, who famously started two funds while still at Harvard, received his first $1 million investment after graduation from the Glenwood Capital vehicle of Frank Meyer, whose instinct for the right combination of intellectual ability and trading knowhow was never more prescient.

However sound that instinct, Meyer is the first to admit that his life could easily have taken a quite different course. What ultimately turned him on to investing was the fear of boredom. It was the mid-1960s, and Frank Meyer was at the University of Chicago School of Business (now the Booth School of Business) teaching statistics. “When my mother used one of my more abstract research papers on finance and complex statistics as a coffee coaster, I questioned whether a career in academia was right for me,” he recalls. “I thoroughly enjoyed my time teaching and I liked statistics a

96

COO

lot. But academia just did not seem right for me. I frequently looked at my colleagues and saw that they had been teaching the same courses for years. This repetitive routine of teaching and the abstract manner of my research did not appeal to me. So I started to look for an opportunity to do something new.”

I frequently looked at my colleagues and saw that they had been teaching the same courses for years. This repetitive routine and the abstract nature of my research did not appeal to me.

That opportunity came in the form of an invitation to work at A. G Becker & Co, a Chicago-based firm which, after many adventures with S.G. Warburg and Banque Paribas, was eventually sold to Merrill Lynch & Co. in 1984. “A friend of mine worked at A.G Becker & Co and told me there was opening,” recalls Meyer.

“I just wanted to get into the real world so I took it.” Becker was in fact a highly distinguished firm, whose alumni include fund manager Richard

COO Person

Frank Meyer As he approaches the start of a fifth decade of investing in hedge funds, Frank Meyer does not need to be told that there is more to life than Sharpe Ratios and Operational Due Diligence. But even though he has measured and managed investment risk for longer than the lifespans of most hedge fund managers active today he still loves to be involved, hands-on, in backing winners.

COO

97

COO Person

H. Driehaus, Lehman Brothers investment banker Lew Glucksman, and former US defence secretary Donald Rumsfeld. But Meyer struggled to persuade his superiors of the merits of his methodology for measuring investment performance “When I joined the bank, it had no concept of what constituted alpha or risk,” he says. “For three years, I tried to remedy that.”

When I joined the bank, it had absolutely no concept of what constituted alpha or risk. For three years, I tried to remedy that.

Eventually, he decided to move on, having noticed that the rewards of the salesmen had tripled while his own earnings had barely kept pace with inflation. “I was part of the business’ cost centre and not the revenue centre,” explains Meyer. “So I felt change was right.” In 1973 he joined former A.G Becker analyst Richard Elden at Chicago-based Grosvenor Capital Partners, the first ever fund of hedge funds in the United States, as co-manager. Their aim was simple: to invest in up and coming hedge funds.

98

COO

Although Alfred Winslow Jones had established the first “hedged” fund as far back as 1949, and his technique was lauded in a famous Fortune magazine article in 1966, investment bankers and investors were remarkably slow to imitate his invention. In the early 1970s, Meyer and Elden found themselves surveying almost virgin territory.

If the early investments of Grosvenor Capital Partners read like a Who’s Who of the history of the hedge fund industry it is because Meyer and Elden had the courage to back the pioneers early in their careers. “We were the first funds of funds in the United States,” says Meyer. “Comparing the hedge fund industry in the 1970s with the industry today, it is almost unrecognisable. Managers were so much smaller. Therefore there was a lot more transparency, as they were unafraid that people were going to copy their positions or trades. Furthermore, many managers publicised their shorts, because they would only put on a short if there was a fraud at a business or if it was facing serious calamity down the line. Managers wanted to highlight to the world that a company was bad or fraudulent.”

By that standard, the second decade of the 21st century is indeed

COO Person

I was part of the business’ cost centre and not the revenue centre.

So I felt change was right. another country. As Bob Sloan has pointed out in Don’t Blame the Shorts, short-sellers provide a public service by selling short the stock of companies doing bad things as well as wrong things, but it would be exceptionally hard to persuade a politician of that truth today. Far from wanting the world to know about their trades, the hedge fund managers of today are paranoid about the vulnerability of their positions to prime brokers, competitors and computer hackers, putting at risk their ability to perform and so retain their investors. This is why modern managers, and especially those using complex quantitative techniques, give investors so few details of how their methodologies work. It fuels complaints that leading hedge funds are opaque, over-priced and contemptuous of investors of limited means.

This was not a problem forty years ago. “Because there were so few investors in the 1970s, there was no competition to get a manager,” recalls

Meyer. “Nowadays, if a brand-name trader launches a new fund, investors need to rush to the door before the fund hard-closes. In those days, investors talked to each other because regulators limited managers to only 14 investors, and those investors were treated more fairly.” But Meyer is not nostalgic. “It is very easy to harp on about how ‘great’ life and work was in the good old days but people have a habit of forgetting there have been so many improvements in other areas of the industry since then,” he says.

“Change is great and the industry has achieved so much.” He cites computer technology as an instance in which Moore’s Law has democratised access to quantitative strategies, and created entirely new strategies, by drastically cutting the cost of computer power.

Because there were so few investors in the 1970s, there was no competition to get a manager. Nowadays, if a brand-name trader launches a new fund, investors need to rush to the door before the fund hard-closes.

COO

99

COO Person

Meyer sees the 1980s as the decade when the hedge fund industry came of age. The vast fortunes assembled by successful managers such as Paul Tudor Jones and Louis Bacon attracted talent, but also a lot of managers whose talents were less than obvious. “A lot of billionaires emerged from hedge funds,” says Meyer. “Predictably, when managers are making fortunes like that, it attracts a lot of people.

In the 1970s, there were a couple of hundred funds. Starting in the 1980s and peaking in the mid-Noughties, there were tens of thousands of new hedge funds. Despite this growth, the number of successful managers stayed low relative to the number of launches.” As it happens, it was in the middle of that decade that Meyer left Grosvenor. In 1986, in search of a fresh challenge, he joined private equity firm Knightsbridge Partners.

He did not stay long. Meyer had intended to help Knightsbridge

A lot of billionaires emerged from hedge funds.

Predictably, when managers are making fortunes like that, it attracts a lot of people.

100

COO

integrate hedge fund investing with its original business of private equity.

He was involved in several of the leveraged buy-outs that characterised that era, of which the most notable was the purchase in 1987 of the discount hairdressing chain Supercuts, in a deal underwritten by the soon-to-fail investment bank Drexel Burnham Lambert. October that year also saw the infamous Black Monday stock market crash. The Dow Jones fell by almost 500 points, wiping out thousands of margined investments and taking almost every financial institutions by surprise. “In 1987, there was a big decline, and I was concerned that my private wealth could decline too,” recalls Meyer.

“One of the advantages of funds of funds is that they mark everything to market, which is not a luxury afforded to private equity funds. I needed to know where I stood, so I left Knightsbridge.” He went on to found Glenwood, another fund of funds, in 1988.

It was Glenwood which backed the then unknown Harvard undergraduate Ken Griffin with his first $1 million in seed capital. “Ken was still in college when I met him,” explains Meyer. “He loved what he did, and during his student days he was trading convertible bonds out of his dorm.

Ken was incredibly entrepreneurial

COO Person

and, even before he set up his investment management firm, he had been successful at selling software.

While at college he recognised that it was important to take disadvantages and turn them into advantages. For example, he played on the firm’s nimbleness to his advantage. He went to the head of stock lending companies and introduced himself and got great terms on stock borrows.

He ran his business out of his dorm in an incredibly creative way.” To say Meyer got lucky with Griffin would be wrong (it is his early eye for investment talent that made Meyer so successful) and it would be an understatement even if it was right.

Griffin earned 70 per cent on that first $1 million. It was more than enough for Meyer to get him some more. Ken Griffin launched his first hedge fund in 1990 with $4.5 million.

At its pre-crisis height, Citadel was running $20 billion, and sported not only a large technology department but the ambition to develop a broker-dealing arm capable of competing with Goldman Sachs and Morgan Stanley. The Citadel back office was the first to coin the phrase “operational alpha,” and it became enough of a business in its own right for Northern Trust to buy it for at least $100 million in the

summer of last year. If Meyer never doubted that Ken Griffin would be a success, even he is surprised by quite how successful he became. “If you asked me in 1989 whether a manager trading convertible bonds in his dorm would run a business like Citadel, I would have been sceptical to say the least,” he says. “When I met Ken, he was a shrewd investor but he was just 19, and at that age, it is impossible to identify whether or not a person can run an organisation. He had never managed anyone in his life so I would never have predicted he would run a firm like Citadel.”

When I met Ken, he was a shrewd investor but he was just 19, and at that age, it is impossible to identify whether or not a person can run an organisation. He had never managed anyone in his life so I would never have predicted he would run a firm like Citadel.

Jackpot-hitting successes such as that helped Glenwood generate healthy returns for its investors in the 1990s. Its performance attracted the COO 101

COO Person

interest of Man Group, which was then trying to parlay a reputation for commodities brokerage into the higher yielding—and ostensibly lower risk—hedge fund business. Initially, Glenwood acted as an investment advisor to Man, but after a brief trial period Meyer proposed a joint venture which combined the manager-picking skills of Glenwood with AHL, the managed futures business of Man Group. The JV gave birth to the Man IP220 series of capital protected funds of funds which are still offered to investors today. In 2000 Meyer sold his firm outright to Man, whose distribution network lifted Glenwood assets under management (AuM) to over $5 billion by the time he retired completely from Glenwood at the end of 2004. “I made the sale to Man for a variety of reasons,” explains Meyer.

“I wanted to give stability to my employees lest I died and the business could not continue. I wanted the business to retain value. Hence the sale to Man.” That looming sense of mortality was triggered by the sudden death of a friend, James Cantalupo, the chairman and chief executive officer of McDonalds. “He was the same age as me, and was born the same month as me,” says Meyer. “It was a shock, and made me realise that I was mortal too, and it could happen 102

COO

to me.” Unfortunately, Glenwood did not thrive as part of the Man family.

Although its AuM had increased to $6.9 billion by 2008 and—unlike another Man fund of funds, RMF Investments—had no exposure to Bernie Madoff, Man amalgamated Glenwood and RMF in 2009 into a single $23 billion fund of funds, as part of an early cost-cutting exercise.

Most of the savings came from cutting the payroll at Glenwood.

Meyer makes no secret of his dismay.

“My biggest regret was that I did not recognise there would be strategic issues for Glenwood within Man,” says Meyer. “I sold the business to Man because I wanted to give stability to my employees. I thought they were going to have a job for life when I exchanged. Sadly, this did not happen and all of my staff, who I thought I was giving job security to, were laid off.”

I thought they were going to have a job for life when I exchanged. Sadly, this did not happen.

There is consolation in the knowledge that Grosvenor Capital Management is still in business, nearly forty years after Meyer

COO Person

joined the firm in 1973. The firm, now running over $20 billion out of offices in London and Tokyo as well as Chicago, actually enhanced its reputation in the crisis, growing AuM even as others lost fortunes to the markets and Madoff. Meyer is not surprised, arguing against the conventional wisdom that the crisis put funds of funds to the ultimate test, and that they failed it.

“The fund of funds business is an excellent place to invest,” he says.

“Of course, there are negatives—for example, if a fund of funds invests in a manager who suffers from bad performance and imposes restrictions on redemptions. However, the fund of funds space will flourish because there are still investors who do not have the operational due diligence infrastructure, and they will continue to rely on funds of funds to do that work for them. Furthermore, a lot of investors will not meet the minimum investment requirements of single managers, so it is useful to go through a fund of funds. Funds of funds will remain popular among smaller pension funds, endowments and high net worth individuals.”

It would be surprising if Frank Meyer said anything else. He is still involved in the fund of funds business, advising the Skybridge Capital fund of funds business run

by Anthony Scaramucci. (“I do a bit of work with them and gave them advice on how they could improve their business,” as he puts it.) He is still fancies the convertible strategies that drew his attention to Ken Griffin 20-odd years ago, sitting on the board of Ferox Capital, and on that of mezzanine lender Fifth Street Financial Corporation. Meyer has not lost interest in his personal portfolio of investments either. But his real passions now are spending time with his wife (“If we do not do it now, when will we do it?”) and his charitable interests. He and his wife run a charity that offers college scholarships to promising children from disadvantaged backgrounds.

“We do not just give these kids a scholarship,” explains Meyer. “We provide a lot of mentoring too. Many of them come from poor families, and often they do not know basic things like reading fine print on a credit card agreement or managing their own finances. We teach them these things so they can get through college and graduate. We are there to help young people reach decisions for themselves. For example, one girl wanted to join a particular college sorority and we asked her to look at the reasons why she should join.

We asked her to look at the grade average and employment rates after COO 103

COO Person

the college. She made the ultimate decision to join another sorority that was focused on charitable works.

We had encouraged her to think for herself and ask questions about which path she wanted to go down.”

It is an approach to helping people that is not hugely different from helping talented fund managers, and Meyer knows it. “Getting hedge funds accepted as viable investment opportunities for investors is something I take a lot of pride in,” he says. “I was also one of the first people into seeding, which again is something I am proud of. Spotting new talent and investing in new businesses and giving them support is something I thoroughly enjoy.” In fact, it can be argued that finding the right balance between giving people responsibility, and ensuring they live up to that responsibility, is the philosophy Frank Meyer has applied to all aspects of his life. He criticises those hedge funds that mistreated investors in 2008-09, for example, by imposing gates and parking illiquid assets in side-pockets. “In the last few years, we have seen a lot of frauds and gates at hedge funds, as well as a refusal to let investors redeem assets,” he says. “Even today, investor agreements are too favourable to the manager. I believe this is going to change because many of the 104

COO

aforementioned abuses were able to occur only because of the restrictive documentation investors signed.”

Getting hedge funds accepted as viable investment opportunities for investors is something I take a lot of pride in.

Indeed, despite mounting scepticism over their popularity as memories of the crisis recede, Meyer predicts a boom in separate accounts, precisely because they offer clients a greater degree of control over assets.

“Large investors will be able to get separate accounts, although smaller investors might not be as fortunate,” he says. “I believe there will be a development of new structures, whereby all investors get the protections of separate accounts, even if they are in a pooled vehicle.” This counter-intuitive observation—after all, fund managers oppose separate accounts and favour pooled funds because they simplify the investment process, reduce the administrative burden, lower transaction costs and facilitate risk management—has the familiar purpose of aligning freedom and responsibility. “I do envisage deep-pocketed investors working with

COO Person

fund administrators and getting much more control over the accounts,” insists Meyer. “I could even see some administrators being taken over by large institutions. This could give peace of mind to investors who are worried about style drift.”

Certainly Frank Meyer believes investors will do a better job of helping the hedge fund industry recover its poise and its reputation than the regulators. “Regulation is always imposed whenever something awful happens,” he says. “But before you can expand regulatory authority, it is essential that you look at the job regulators have done so far.

Look at the Securities and Exchange Commission (SEC), for example.

The SEC gave Madoff a clean bill of health despite auditing him several times. Harry Markopolos, a hedge fund manager, repeatedly told the SEC that Madoff was running a Ponzi scheme. More recently, the Commodity Futures Trading

The regulators should not be passing more rules if they cannot make the existing ones work, or at least until they prove that they can make them work.

Twitter Bio: University of Chicago; A. G Becker & Co; Grosvenor Capital Partners 1973; Knightsbridge Partners 1986; founds Glenwood fund of funds 1988; sells Glenwood to Man 2004.

Commission (CFTC) was meant to protect investors at MF Global, but the regulators failed—again. The regulators should not be passing more rules if they cannot make the existing ones work, or at least until they prove that they can make them work. The rules are going to ramp up compliance costs by billions of dollars, but I doubt we will see many benefits or improvements to investor protection.” In that judgment, as in so many others over his long career, Frank Meyer is undoubtedly correct.

COO 105

COO Analysis

PUBERTY BLUES Two years ago, Asia promised to become the salvation of the hedge fund industry. Amid less-than-stellar returns in 2011, slow growth in AuM, caution from domestic investors, a growing appreciation of the size and complexity of the region, and signs that local regulators are more responsive to American and European regulators than American and European hedge fund managers, a sense of reality is settling over the region.

A

senior HSBC executive compares the current state of the Asian hedge fund industry to pubescence. As analogies go, it is a fitting one. Hedge funds based in Asia have matured noticeably in the last two and half years, but remain worryingly temperamental, and some way short of adulthood. They out-performed their global rivals in 2010 as investment capital switched its attention from the ailing and unstable economies of Europe. That year, Asia ex-Japan managers delivered returns of more than 10 per cent, according to Hedge Fund Research. That same year, according to Eurekahedge, the Japanese alternatives industry put on 6.8 per cent in a period when the Nikkei 225 sank by 3 per cent.

But it was not just returns that made Asia look attractive in 2010. With European regulators threatening to place fresh burdens on the hedge fund industry, notably through the Alternative Investment Fund Managers Directive 106

COO

(AIFMD), the region looked like a tempting alternative location from a regulatory perspective as well. European managers talked about moving some or all of their operations to Hong Kong and Singapore, where tax regimes are generous, regulation light, and hostile political rhetoric less vociferous than at any time since the Asian flu crisis of 1997-98. In 2010, the hedge fund industry understandably saw Asia as its future.

The euphoria of 2010 is not the reality of 2012. Despite all the talk of hedge funds shifting to Asia, assets under management (AuM) in the region currently stand at $125 billion—a figure which is still well below the peak of $176 billion attained in 2007. Worse, no less than 123 Asian hedge funds closed in the first ten months of 2011, according to Eurekahedge. That is only two fewer than went out of business in the whole of the annus horribilis of 2008. The average Asia ex-Japan hedge fund lost 17.21 per cent last year, according to Hedge Fund

COO Analysis

Research, placing the region ahead of there are now 21 hedge funds managing Russia and Eastern Europe only. more than $1 billion in Hong Kong (13) In retrospect, it is obvious that Asia and Singapore (8). “Asia, as a region, is was over-hyped in 2010. The interesting where the US and Europe was 15 years question now is whether it was over-sold ago,” says Ken Heinz, president of Hedge in 2011. “It is unfair to say that Asia Fund Research. “2011 was difficult for is over-rated as a hedge fund market,” a variety of reasons, such as slowing counters Marlin Naidoo, head of the growth in China and the contagion effect hedge fund capital group for Asia-Pacific from the Eurozone.” at Deutsche Bank. “I would say Asia is The impact of those events was felt still a growing, maturing market, which primarily in the equity markets, with has yet to reach its full potential.” Paul predictable knock-on effects on an Asian Smith, chief executive officer of Triple hedge fund industry still dominated A Partners, a fund management and third by equity long/short strategies. “As party marketing firm in Hong Kong, says things stand now, there is a big equity patience will be rewarded. “The hedge long/short base but not that much to fund world is still very new to the region choose from, particularly if investors and domestic Asian investors, particularly want diversity,” says Paul Smith. high net worth individuals and family Equity long/short also suffers from offices, still prefer to put their assets into technical constraints which exacerbate property,” he says. “It takes about eight volatility, notably illiquidity and lack of to ten years of working in Asia before the stock to borrow. “Much of the supply tree bears fruit. However, the Asian hedge for securities lending in the Asian fund market and investor base will be markets is still untapped, which huge in decades to come and it means liquidity can often dry cannot be ignored.” up, particularly in volatile Despite the gloom, last markets,” says Marlin Naidoo. year saw some large and high This is one reason prime profile launches. Azentus brokers struggle to make Capital, the multi-strategy money is an issue. Another is fund established by the sheer scale of the region, Morgan Sze, a former and the cost of covering it prop trader at Goldman when talent is short, AuM Sachs, hard-closed to is low and investment Ken Heinz, investors at $2 billion. strategies are poorly President of Hedge Fund Intelligence says Hedge Fund Research diversified.

COO 107

COO Analysis

But a shift away from equity long/ that are flowing into the region more short is now under way. Marlin Naidoo generally.” A larger disappointment agrees that “the majority of strategies is the relative lack of interest among in the region are equity long/short” but investors in a region thick with high net adds that “we are seeing more managers worth individuals of exactly the kind coming to market offering macro and that seeded the growth of the hedge fund multi-strategy hedge funds.” Tim industry in North America and Europe.

Rainsford, former managing director for According to the World Wealth Report Asia at Man Investments, and now head

by Capgemini and Merrill Lynch Global of sales for Europe, agrees. So does Paul Wealth Management, Asia has seen its Smith. “Increasingly managers with population of high net worth individuals macro, event-driven and some credit rise to 3.3 million, overtaking Europe for strategies are also establishing a local the first time, and placing the region just presence although these are a much behind North America. smaller percentage,” he says. “The market Marc Gilly, co-head of capital is young and it is often a challenge to introductions at Goldman Sachs, is operate fixed income or derivatives understandably excited. “Asia in the strategies. Over the next few years, medium to long term is interesting,” I anticipate we will see a lot he says. “It is the biggest centre more fixed income and fixed of wealth creation over the past income hedging strategies, as 50 years since the US baby well as arbitrage, commodity boom, and as a consequence trading advisors (CTA) and is of primary importance FX.” Heinz adds that “we are to fund managers. already seeing more esoteric Relationships need to be strategies being marketed built across Asia, whether out of the region.” it is Australia, China, Hong This last remark is Kong, Singapore or any Paul Smith, telling. Asian hedge funds other countries. We have a Chief executive officer of are still raising the bulk of full team there and based Triple A Partners their capital outside the region. on our experience, Asian “Most investors are from Europe investors are incredibly smart and and the United States, but these allocators very engaged.” Paul Smith is not so sure, tend to opt for the big names in the arguing that high net worth individuals region,” explains Paul Smith. “Although and family offices in the region still I am disappointed with the level of assets lack sophistication. Tim Rainsford 108

COO

COO Analysis

agrees. “Generally the Asian investor base for hedge funds is still relatively unsophisticated and new to hedge fund investing,” he says.

Both Smith and Rainsford allude to bad memories. Though these include the spirited denunciations of the hedge fund industry by Mahathir Mohamad, the former prime minister of Malaysia, in 1997-98, current perceptions are coloured by the more recent Lehman mini-bond fiasco. Thousands of retail investors in Hong Kong and Singapore lost their savings by investing in what were sold as rock-solid bonds, but which turned out to be complex structured products. The cost of making them whole has made regulators, as well as investors, more conservative. “The Lehman mini-bond debacle has forced regional regulators to focus on education around product mis-selling, as well as the appropriateness of hedge funds for the retail investor,” says Rainsford.

Though Rainsford adds that private banks are already active distributors of hedge fund products to their high net worth individual clients it is institutional investors that he sees as the best long term prospect for the industry in the region. Unfortunately, they are a highly diverse and geographically scattered group. They are also apt, like their counterparts in Europe and North America, to listen to consultants. “The investor base in Asia for investing into

single strategy hedge funds consists primarily of Asian pension funds, sovereign wealth funds and insurance companies,” explains Rainsford.

“Consultants are beginning to advise a much broader range of institutional investors, and family offices are increasingly comfortable with investing in hedge funds.”

It is Japanese institutions, and especially pension funds, that remain the highest priority target for capital raisers.

A survey by Hedge Funds Club Advisory, a Tokyo-based consultancy, found 42 per cent of Japanese institutional investors were looking to increase their hedge fund capital allocations, with global macro and managed futures being the most popular strategies. Though most institutions still prefer liquid strategies, a minority were willing to invest in distressed and credit strategies. A clear majority of Japanese institutional investors (58 per cent) allocated to both single managers and funds of funds. “Japanese investors are very experienced hedge fund investors and have been allocating for a long time now,” says Marlin Naidoo.

He also sees enticing possibilities in the burgeoning Australian superannuation industry, although—in typical AngloSaxon style—consultants are overly influential there too. “Australia is another market managers are trying to tap,” explains Naidoo. “However, institutional investors in Australia have historically COO 109

COO Analysis

invested in brand names, and are in many a Singapore office to its operations in circumstances dependent on consultants.” London and New York, is not untypical.

At a time when the competition for “A lot of international organisations the attention of institutional investors are opening houses in Asia and is growing, getting the attention of even putting portfolio managers on allocators across such a large and diverse the ground so they are closer to the geography is more challenging than ever. markets,” says Matt Kiraly, head of sales “Hedge fund managers must realise it and marketing for HSBC Prime Services is not an easy ride in Asia,” warns Paul in Asia-Pacific. But winning the trust Smith. “A lot of funds are spinning out of Asian investors takes time and work, of prop desks, and it takes time to make and inevitably requires patience. In fact, a name for oneself in Asia. It is tough this is true even of North American and raising assets and it is essential to have a European investors switching assets track record, and people in the region.” to the region. “Significant amounts of Some fund managers have long capital are moving from west to east, but understood this. Man Group first came the demand for hedge fund strategies is to Asia more than 15 years ago. What still, although growing, relatively small,” started as a distribution office in warns Rainsford. “To be successful Hong Kong has become a major in this space requires a strong network spanning Tokyo, commitment to the region Singapore and Sydney, and and a willingness to invest nearly a quarter of the AuM of in a local presence and also the firm now comes from the people.” region. Its recent acquisition, It is also easy to exaggerate GLG, also has a long history the attractions of Asian of investing in Asia, regulatory regimes. and gained a trading Hong Kong, for licence in Hong Kong in example, may offer Matt Kiraly, 2010. But less well-known less onerous compliance Head of sales and marketing for HSBC Prime fund managers are now than Brussels, but it is by Services in Asia-Pacific taking the advice of Paul no means a light-touch Smith seriously, and bolstering regulator. “The Hong Kong their operations, investor relations and Securities and Futures Commission sales departments in the region. Algebris (SFC) is not dissimilar to the UK Investments, a multi-billion dollar Financial Services Authority (FSA),” credit manager which in 2010 added says Kiraly. “Overall, it is a robust and 110

COO

COO Analysis

respected regulatory scheme.” Singapore, on the other hand, has adopted a much less aggressive approach to regulating its $53 billion hedge fund industry.

But this may be about to change. The Monetary Authority of Singapore (MAS) is proposing that fund management companies with more than $250 million in assets obtain a licence, while smaller funds must register with it prior to launch.

All firms will be required to have systems to monitor the risks they are running, and it will be mandatory to have at least two qualified investment professionals on the management team. These rules are expected to be implemented this year.

Predictably, there is a chorus of opposition to these moves from industry participants, who argue that the conspicuous change of attitude will lead to local fund closures and an exodus from Singapore, with the more mature financial market infrastructure of Hong Kong providing the obvious alternative destination. “Many Asian markets are tightening their regulatory infrastructure,” says Rainsford. “Singapore has for a long time welcomed and encouraged the establishment of managers. Increased regulatory oversight there may see some offshore managers, who are looking to establish a presence in Asia, look to Hong Kong as an alternative domicile.”

But this is a region notorious for the fierceness of the competition between financial centres, and other Asian markets

are keen to develop an onshore hedge fund industry.

South Korea is chief among them.

Despite mimicking North America and euro-zone countries in imposing short-selling restrictions at times of crisis, Seoul is opening up to alternatives. In June 2011, the authorities announced a proposed revision of the Capital Market Consolidation Act—a measure designed to bolster domestic financial institutions—that will see the liberalisation of some current restrictions on the growth of hedge funds. Under the proposed changes, individuals will be able to allocate capital to hedge funds provided they can meet a minimum investment requirement of 500 million Korean won. Borrowing limits for fund managers will also be increased, but hedge funds will need 6 billion Korean won of capital and at least three fund managers with a verifiable track record to qualify for regulatory approval.

“Regardless of its short-selling restrictions, South Korea is opening up its market and this is an exciting time for managers,” says Glenn Kennedy, regional head of sales for alternatives in Asia-Pacific for HSBC Securities Services. Exciting or not, it would be surprising to find hedge fund managers gravitating to Seoul en masse at such an early stage in its development as a hedge fund centre, especially as the market is still far from liberalised in COO

111

COO Analysis

the most basic sense. “South Korea still has currency controls and it is a restricted market,” explains Colin Lunn, executive director and head of business development and client services for Asia Pacific fund services at UBS. “The rules will encourage more onshore business and domestic long/short Korean equityfocused funds. I doubt many foreign funds will move there but it is still a work-in-progress.”

Unsurprisingly, a recent report found that South Korea had gained just 17 hedge funds managing a mere $440 million in capital since the reforms were inaugurated. South Korea is not, however, the only alternative to Hong Kong and Singapore. In January 2012, it was announced that Beijing would launch a long anticipated centralised securities lending exchange, which is the essential prerequisite to the development of short-selling in mainland China.

“China, obviously, is a huge market, and has the capacity and liquidity to develop a hedge fund industry,” says Colin Lunn.

“China has repeatedly said it wants to encourage an asset management business covering all asset classes. They are already building a futures market, and developing short selling rules, and I anticipate it will be successful in the long-term.”

While the Chinese decision is welcome, it is also a reminder of the many different paths being taken 112

COO

across such a wide geographical area.

Different markets have different rules and regulations, making the physical or synthetic short-selling of stock a potentially hazardous business, and the marketing of investment strategies undeniably challenging.

Until regulators throughout the region agree uniform rules and regulations, hedge fund managers must necessarily maintain a cautious approach. “I suspect it will be a two-pronged development process between Greater China, covering China, Hong Kong and Taiwan, and south east Asia, which will incorporate Singapore and other regional economies, with Australia working with both,” predicts Colin Lunn. “However, I think full uniformity, should it ever come to pass, is many, many years down the track.”

Even then, regulations may not be entirely encouraging. After all, uniformity in regulation across the member-states of the European Union has not delivered what hedge fund managers would prefer. Asian regulators may be somewhat less intense in their approach to the regulation of the investment banking and hedge fund industries than their counterparts in North America and Europe, but they are still part of the post-2008 drive against the alleged sources of systemic risk in the global financial system. Although Asian regulators are less inclined to see

COO Analysis

the “imbalances” between West and East as part of the problem, hedge fund managers hoping for a straightforward regulatory arbitrage opportunity between Asia and Europe are likely to be disappointed.

Paul Smith says he has yet to see any hedge fund relocate to Hong Kong or Singapore to escape regulation in Europe or the United States. This is not surprising, given the immaturity of the Asian investor base, and the continuing reliance of fund managers on capital raised in Europe and the United States.

The AIFMD, for example, insists that hedge funds marketing to European investors from a third country must operate from a jurisdiction that meets the regulatory standards of the European Union. Colin Lunn thinks this is already affecting the development of regulation in Singapore, since hedge fund managers establishing operations in the city-state want to retain the loyalty of European investors. “AIFMD might explain why Singapore is clamping down and trying to dispel its light touch reputation on regulation,” he says. “Many investors want a better regulation.”

Whether it is “better” than what is on offer in Singapore already, American regulation is also proving exportable, as dismay at the extra-territorial demands of American regulators and tax authorities proves. The obligations on hedge funds selling to American

investors to register with and report to the Securities and Exchange Commission (SEC) in immense detail cannot be escaped simply by re-locating the office to Singapore or Hong Kong while leaving the investors in place. Indeed, mixing Asian investors and American ones will complicate compliance with the dreaded Foreign Account Tax Compliance Act (FATCA).

Under FATCA, hedge funds will have to conduct extensive investigations into the tax status of their investors, and tell the Internal Revenue Service (IRS) what they find out. Failure to comply with the rules will result in punishing fines being levied [see “FATCA is Coming: Their Money, or Yours,” COO, Winter 2011, pages 90-94].

The IRS and its Congressional supporters believe FATCA, which comes into effect on 1 January 2013, could generate $100 billion in taxes.

Asian investors will not want to find themselves, especially inadvertently, contributing to that figure. “With AIFMD, the jury is still out as there is a lot of uncertainty about what to expect,” warns Glenn Kennedy. “But in terms of external regulation, FATCA is certainly a topic that has been thrust to the front of mind. There are major data protection issues, which hedge funds are worried about and they are eagerly waiting for the United States Treasury to sort something out. Many fear they COO 113

COO Analysis

could violate data protection laws if they provide the IRS with information about their clients. We are trying to educate people on an on-going basis about the implications of FATCA.�

In other words, the efforts by American and European regulators to reduce the size of the investment banking and hedge fund industries are not having the beneficial effects on the hedge fund industry in Asia that a superficial analysis might suggest.

Decamping to Asia is liberating only if the investors decamp as well. Though there is competition for business between financial centres in Asia,

the lack of uniformity between legal and regulatory regions, and the sheer geographical extent of the region, make it an expensive and complicated place to do business. Insofar as they are interested in harmonising regulation, Asian regulators seem at present to be influenced more by developments in the United States and Europe than any urge to compete business away from their neighbours. “The changing regulatory environment in the European Union and the United States is causing all managers in Asia, not just hedge funds, to focus on the potential wider implications,� warns Tim Rainsford.

Thirteen thoughts about hedge funds in Asia 1. It is not (yet) the salvation of the hedge fund industry 2. AuM is lower now than it was in 2007 3. Funds are getting bigger 4. 2010 returns were a lot better than 2011 5. There are a lot of equity long/short managers 6. It can be hard to borrow stock 7. Credit and macro and multi-strategy funds are emerging 8. Ex-prop traders are spilling out of investment banks 9. Inbound investors outweigh domestic investors 10. It is Seoul and Beijing versus Hong Kong and Singapore 11. Asia is not a free market haven 12. It is a big place, with many different regulators 13. Re-regulatory fever is infectious 114

COO

MyCOOConnect is a social network business platform for COOs in the fund management industry.

If you would like to know more, call Anita Craw on + 44 (0) 7557 301 812 or e-mail anita.craw@cooconnect.com

www.cooconnect.com Expert Panels | Peer2Peer Chat | Find a Non-Exec Director | Magazine | Webinars | Benchmarking |RFPs | Events Group Networking | Find a Charity | Browse the Library | Surveys | Polls

COO Columns

Kevin Mirabile, Professor of finance at Fordham University

W

hat happened to absolute return? The ability to use short selling, leverage and derivatives to generate returns irrespective of market conditions, and without reference to any benchmark, was once the chief justification for investing in hedge funds. Indeed, the case for performance fees was built on the idea that managers can produce positive returns throughout the cycle.

In the decades that preceded the crisis, a plethora of industry and academic studies claimed to prove that dynamic trading, leverage and short selling could deliver uncorrelated, LIBOR plus 300-500 basis point returns. Initially, hedge funds delivered on that promise. They made single or double-digit net positive returns year-in year-out for 20 years, save minor blips in 1994 and 2002.

Today, performance letters sent to investors, industry commentators and those who study hedge funds are quick to point to the absolute returns funds generated in down years for the markets as a whole such as 2008 and 2011. They never fail to remind readers that hedge funds are designed as much 116

COO

THE VIEW FROM THE IVORY TOWER to preserve capital as add to it—which is why rich people have always liked investing in them.

Hedge funds can play an important role in capital preservation. But I dispute that investors should accept positive relative returns. After all, there are synthetic ways to obtain hedge fund-like returns, which work well enough to threaten the generous fee structure of the industry. Hedge funds that promote themselves on strong performance relative to a benchmark are selling the true stars of the industry short (no pun intended).

Managers who generate absolute returns, from unique strategies and with special skill, should distance themselves from the relative return crowd before it is too late. Investors should be willing to pay above-average fees for absolute returns, and punish funds that fall short. It is not enough to deny managers performance fees in a down year. Managers should give back some of what they earned in prior years. The fees investors pay for relative performance should never be equal to the fees they pay to managers that deliver absolute performance.

... and climbing.

A global player in asset servicing...

Offering leading value in investor services demands constant evolution. At CACEIS, our strategy of sustained growth is helping customers meet competitive challenges on a global scale. www.munier-bbn.com

Find out how our highly adapted investor services can keep you a leap ahead.

CACEIS, your comprehensive asset servicing partner.

Custody-Depositary / Trustee Fund Administration Corporate Trust CACEIS benefits from an S&P A+/A-1 rating www.caceis.com

#1 Capital Introductions #1 in Europe 10 Honors for Financing Global Custodian Prime Brokerage Survey 2011 Most Innovative Prime Broker The Banker 2011 #1 in 13 of 16 categories Global Investor, ISF Synthetic Financing Survey 2011

A prime broker with powerful resources.

When you need a leading prime broker capable of cross-asset class margining, we’re here. With a global coverage model, we deliver timely market color, valuable trading opportunities and insight into market trends.

With offices worldwide, you’ll have access to over 100 exchange and liquidity venues around the world.

You’ll also have access to a strong balance sheet for your structured financing needs. And with one of the largest sources of lendable equity assets through global securities lending, we can help you achieve trading efficiency.

Taking your opportunity further. That’s return on relationship.

Gain insight into the Form PF service provider landscape with our free whitepaper at baml.com/FormPF U.S. +1.646.855.5888

Europe +44.20.799.52838

Asia +852.2536.3757

baml.com/prime

“Bank of America Merrill Lynch” is the marketing name for the global banking and global markets businesses of Bank of America Corporation. Lending, derivatives, and other commercial banking activities are performed globally by banking affiliates of Bank of America Corporation, including Bank of America, N.A., member FDIC. Securities, strategic advisory, and other investment banking activities are performed globally by investment banking affiliates of Bank of America Corporation (“Investment Banking Affiliates”), including, in the United States, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp., both of which are registered broker-dealers and members of FINRA and SIPC, and, in other jurisdictions, by locally registered entities. Investment products offered by Investment Banking Affiliates: Are Not FDIC Insured  May Lose Value  Are Not Bank Guaranteed. TAKING YOUR OPPORTUNITY FURTHER is a trademark of Bank of America Corporation, registered in the U.S. Patent and Trademark Office. ©2012 Bank of America Corporation 04-12-1080