Hedge fund consultant J. Alan Lenahan agreed that far more attention is being paid to financing, given recent events. Its always been an important question for us, but it wasnt the No. 1 question we asked. Now its on everyones mind and everyone is monitoring counterparty risk very carefully. Mr. Lenahan is director of hedge strategies at consulting firm Fund Evaluation Group LLC, Cincinnati.
Weve been getting many more questions about our financing arrangements in the last six weeks. Investors want to know who were borrowing from, the terms, what exactly we own and who we own it with. It used to be that operational due diligence teams were more concerned with process and our investment strategy than about detailed specifics. Thats a big change, said Anoop Dhakad, managing director and head of marketing and business development at MKP Capital Management LLC, New York. MKP manages $5 billion in fixed-income and macro hedge fund strategies.
Ultimately, the main question for investors is whether or not the hedge fund manager is in control of their financing, said Stephen L. Nesbitt, CEO of alternatives consultant Cliffwater LLC, Marina del Rey, Calif.
Who controls the financing equation is an issue that both hedge fund managers and prime brokers are wrestling with now.
One result of much tighter capital pools is that prime brokers have become more discriminating to whom they will lend, and are favoring well-established hedge fund managers with which they can develop long-term and lucrative relationships.
The Street is undergoing its own transformation and is getting pickier about who theyre willing to lend to. Theyre looking at the relationships they can establish for the next five or 10 years. Theyre much more willing to lend to a large, well-diversified hedge fund that offers (the broker) transparency about what it owns, that has a crack system of people and processes, and applies a robust risk management system, Mr. Dhakad said.
If youre a $100 million fund or a manager with a narrow strategy, youre not worth their time.
Prime brokers are lining up the counterparties and are rating them A, B, C, D and are picking those firms they want to be working with for the next 10 years. Theyre out there courting those premier funds, agreed the CEO of a large hedge fund of funds who asked not be identified.
With credit so tight, prime brokers have to ration what capital they have, and they likely will give it to the bigger managers that they have or can build long-term relationships with, said Cliffwaters Mr. Nesbitt.
But hedge fund managers also are subjecting prime brokers to their own smell test, sources said.
Who youre trading with matters. Hedge funds are asking a lot more questions about the type of counterparties theyre using. Theres a lot more counterparty risk than there was in the past. Both the lender and the borrower want to know whos on the other side of the swaps. This is an issue that wasnt talked about much until recently, said Ron Papanek, market strategist at RiskMetrics Group Inc., New York, a risk systems provider.
Hedge fund executives also are concerned about the security of their prime broker, following the collapse of Bear Stearns Cos. Inc., New York, said John Jack Huber, a director at Pershing Prime Services, an affiliate of Bank of New York Mellon Corp., New York.
Bear Stearns prime brokerage practice was used by a large number of hedge funds that had to scramble to evaluate whether they should leave their accounts with Bears new parent company, JPMorgan Chase & Co., or move them to other prime brokers.
The reason for their concern is fundamental: Prime brokers hold hedge fund managers cash and securities. The stability of a prime broker is of prime importance to a hedge fund, Mr. Huber said.