Hedge funds confront impact of new regulations and evolving prime broker relationships

Wednesday 02 December 2015

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  • 29% of funds surveyed experienced prime broker price increases in the past year and 22% anticipate future increases
  • Hedge fund managers are exploring alternative, non-traditional financing sources
  • Asset growth remains top strategic priority for 57% of hedge fund managers

Hedge fund managers are experiencing the ripple effects of new regulations on banks and prime brokers, with funds facing increased trading fees and broader changes to business relationships. These dynamics place additional pressure on margins and are leading managers to seek new growth strategies, according to The evolving dynamics of the hedge fund industry, EY’s 2015 Global Hedge Fund and Investor Survey.

Regulations such as Basel III and Dodd-Frank have caused banks and their prime brokerage businesses to focus more closely on liquidity, balance sheet capacity and funding. This in turn has resulted in changing economics for fund managers who finance trades through prime brokers. Twenty-nine percent of survey respondents said their prime brokers increased fees in the past year, and an additional 22% expect an increase in fees within the next year.   

Fund managers using strategies such as distressed credit, fixed income and global macro – which can be balance-sheet intensive from the prime brokers’ perspective – have been among those who have experienced price increases the most. Respondents now expect price increases and broker limitations to change the way they trade, including moving toward swap-based trade execution and reducing repo financing and overall leverage.

EY’s Oceania Wealth and Asset Management Leader, Antoinette Elias says these dynamics are the newest challenge to an industry continuing to grapple with margin compression, heightened competition for asset growth and ongoing technology investment requirements.

“All forms of financing are becoming more expensive for the majority of managers, and this has a direct effect on overall trade economics. Investors will be indirectly affected by the increasing costs and will need to rely on communications from the manager to understand the full effect on the fund’s performance,” Elias says.

“In the Australian market we are seeing  a range of new funds being launched. These funds, like existing funds, are also facing the challenge of delicately balancing increasing costs with increased competition to attract investors.”

Hedge funds expand their prime broker relationships

Regulatory changes have also altered the traditional business relationship between prime brokers and hedge fund managers. Many prime brokers are becoming reluctant to hold cash for hedge funds because of how such balances are classified toward banks’ capital reserves under new regulations. Fifty-eight percent of hedge fund managers have moved cash to custodians as a result, while 35% have purchased highly liquid securities as cash alternatives.

EY’s Oceania Hedge Fund leader, Jon Pye says: “Many prime brokers have less capacity to offer than in the past, so hedge fund managers are increasing the number of relationships they have to reduce counterparty capacity risk. As a result of these shifting industry dynamics, we are seeing an increasing need for hedge funds to dedicate individuals to manage their counterparty risk, collateral and treasury.”

Managers seek financing from non-traditional sources

Hedge fund managers are also beginning to explore non-traditional financing sources, outside of prime brokers. Thirteen percent of respondents are seeking or plan to seek financing from non-traditional sources in the next two years. The alternative fianance sources being considered include institutional investors, sovereign wealth funds, custodians and other hedge funds.

Asset growth remains top strategic priority

Achieving asset growth to counteract margin pressure is the top strategic priority for 57% of managers surveyed. New growth methods include adding new hedge fund strategies, identifying new investor bases and increasing penetration with existing investors.

New product launches, which was the top method for achieving growth in last year’s survey, has dropped to less than 20% this year. New products have presented opportunities for managers, but they also have come with challenges, as 24% of managers reported that new products had a negative impact on operating margins.

“As the hedge fund business has evolved, increased competition, as well as heightened demands from investors and regulators alike, has compressed margins via the two-fold squeeze of lower top-line revenues and larger expenses. Growing assets to critical mass within a shorter timeline is critical for managers looking to run profitable organisations,” Pye says.

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About the survey

The purpose of this survey is to record the views and opinions of hedge fund managers and investors globally on topics including managers’ strategies to achieve growth; investor demand; changes in the prime brokerage relationship; middle-office outsourcing and technology; and the future landscape of the hedge fund industry.

From June to September 2015, Greenwich Associates conducted 109 telephone interviews with hedge funds representing more than US$1.4t in assets under management. Research also included 57 telephone interviews with institutional investors (fund of funds, pension funds, endowments and foundations) representing nearly US$1.83t in assets, with approximately US$413b allocated to alternative investments. The complete survey is available at ey.com/hedgefundsurvey.