Explicit leverage is money or assets contractually borrowed for a fee. As a hedge fund investor, it is important to know whether your hedge funds are using these types of products and how much risk they add to your portfolio. One way to figure this out is by reviewing the often overlooked audited financial statements. Many investors glance through these reports at lightning-fast speed with little interest in the details. Yet, investors can actually get a lot of great information from these reports, especially with regard to a fund's use of explicit and implicit leverage. More specifically, explicit leverage can be found on the balance sheet of a hedge fund by comparing total fund assets to the net assets, with the difference being approximately the amount of fund-level explicit leverage.
Prime brokers are the primary counterparties providing explicit leverage to the hedge fund industry. From a counterparty risk perspective, however, hedge funds could better protect their assets by holding them in a custodian bank account rather than a prime brokerage account. Nevertheless, the majority of hedge funds keep their assets in prime brokerage accounts to obtain explicit leverage, while also benefiting from larger prime broker relationships. The main types of explicit leverage include shorting, prime broker financing and repurchase agreements.
When a hedge fund manager “shorts” a security, the manager receives cash for selling a borrowed security, which the manager must purchase back from the prime broker in the future. The borrowed cash can then be used to purchase more securities, giving the hedge fund the ability to buy more assets than the value of the fund.
Shorting is an explicit form of leverage and, as such, an investor can see all the information pertaining to that short position directly on a hedge fund's balance sheet. Specifically, the liability section on a balance sheet will have a line item called “Securities Sold Short.” This line item will detail not only the fair value that the fund owes to the prime broker at the date the short positions are to be closed out, but also the total cash proceeds given to the hedge fund when the short was entered. In addition, explicit leverage also has costs that can appear on an income statement. For example, shorting has associated costs, including stock-borrow fees and dividend expenses. Stock-borrow fees are self-explanatory but some investors do not realize that a short borrower bears an additional expense when dividends are paid by the shorted stock. Sometimes these items are rolled into one expense line and not broken out on the income statement separately. Accordingly, investors should ask their managers to give them details on these items to see how much shorting has cost the funds.
Hedge funds can also get additional leverage from their prime broker. Depending on the jurisdiction and the prime broker being used, the rules might differ. The basic concept is that a prime broker will extend credit to a manager in exchange for the manager putting up cash and securities to be held in custody as collateral. The amount of collateral needed from the manager can be based on either the entire value of the manager's portfolio or can be determined on a security-by-security basis. When considering the value of the entire portfolio, a prime broker considers all of the fund positions in the aggregate to assess the amount that the broker is willing to lend to the fund. This is otherwise known as portfolio margining. When collateral is determined on a security-by security basis, a prime broker “haircuts” the value of the security to some degree, lending less than the full value based on the riskiness of the security itself.
In the past, prime brokers have been able to lend to hedge funds very cheaply. However, the heightened regulatory environment that banks face as a result of Basel III and Dodd-Frank has made this practice more difficult because of higher internal capital requirements. As a result, prime brokers are becoming more conservative about lending assets to hedge funds, putting pressure on fees for this sort of financing.
In many cases, prime broker leverage can be tracked by analyzing hedge fund investments: if the total investment in securities less the cash from shorting is greater than the net assets in the fund, the hedge fund is probably using some type of prime broker leverage. If it is apparent that the hedge fund is borrowing from a prime broker, an investor should review the interest expense line item on the income statement of that hedge fund. This line item is primarily the interest charged by the prime broker for extending its line of credit.
Repurchase agreements, or repos, are also a common way for hedge funds to gain additional leverage. When a hedge fund enters a repo agreement, the hedge fund sells a security it owns to a repo counterparty (normally a prime broker), receiving cash and promising to repurchase that same security at a fixed price on a future date from the counterparty. By doing this, the hedge fund obtains exposure to the position while retaining the ability to use the cash for other investments during the term of the repo. When the repo expires, the counterparties either have to enter into another contract to continue to finance the security or the hedge fund pays for the security. Because of the complexity of these arrangements, cash management is critical to the hedge fund. On the balance sheet, the amount that a hedge fund has financed through repos is also shown in the liability section. The cost of these agreements to the fund is not as transparent as other forms of explicit leverage because the prime brokers make money on the spread between the purchase and sale price on the security in the contract. However, investors can look to the footnotes of the financial statements to discern important details around these contracts.