One of the key differentiators between hedge funds and other investment vehicles is the use of leverage. Leverage can be your best friend one day, and your worst enemy the next. Everyone knows that leverage will accentuate both gains and losses. However, less is known about how hedge funds actually obtain and incorporate leverage into their portfolios and how investors should monitor a hedge fund’s use of it.
In considering these details, an investor should have a foundational understanding of the two types of leverage: explicit leverage and implicit leverage. These two broad categories of leverage may affect the portfolio in different ways, both off and on the balance sheet. And, it is essential to be aware of the existence of both types of leverage before an investor can fully monitor and assess the risk associated with their investments.
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 (“PBs”) 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 benefitting from larger PB relationships. The main types of explicit leverage include shorting, prime broker financing and repurchase agreements.
Shorting – 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 PB 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 PB 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.
Prime Broker Leverage – Hedge funds can also get additional leverage from their prime broker. Depending on the jurisdiction and the prime broker that the hedge fund is using, the rules may 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 out 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 due to higher internal capital requirements.1 As a result, prime brokers are becoming more conservative about lending out 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 (“repos”) – 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 currently 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 repo agreements 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.
Unlike explicit leverage, implicit leverage does not show up on a hedge fund’s balance sheet. In fact, implicit leverage is commonly referred to as off-balance sheet financing. Implicit leverage can take various forms, some riskier than others. This type of leverage includes options, futures, forwards and swaps. From a leverage perspective, these products allow investors to receive the economics of a security without having to put up the money to purchase it. With options, a premium is paid for this leverage primarily because of the limited downside; the maximum the investor can lose is the premium paid for the option. However, with futures, forwards, and swaps there is no up-front premium; the costs are embedded in the contract.
It may seem counterintuitive to review financial statements for off-balance sheet leverage. But, if an investor knows where to look, the audited financial statements can also be used to determine exactly how much exposure the fund has to implicit leverage products. Even though you won’t find this information in the balance sheet, the footnotes to the financial statements typically aid in identifying these risks. The audits of all hedge funds that use off-balance sheet leverage will have a footnote titled “Derivative Instruments.” This note is critical in understanding the amount of leverage that a hedge fund is employing. Each one of these notes will detail “notional amounts.” For derivatives, the balance sheet and the schedule of investments in the audit will only identify the unrealized gain or loss associated with a derivative position, and it will not say anything about the amount of exposure the fund has to a particular derivative contract. Therefore, the notional amounts in the footnotes describe exactly how much aggregate exposure the fund has to each type of derivative.
For example, consider two hedge funds, “Fund A” and “Fund B,” each with $10m of exposure to a particular bond. Fund A purchased the bond with cash and Fund B obtained $10m of exposure to the same bond through a total return swap. While both funds have the same risk exposure to the bond, Fund B doesn’t have to put up any money for the bond which allows it to use the cash for other purposes. If the bond goes down 10%, Fund A has a $9m position, but Fund B now has to come up with $1m in cash or collateral to post to their swap counterparty depending on their margin requirement. If Fund B doesn’t have that $1m, it will have to liquidate other securities to raise the cash or otherwise face a “margin call.”2 Even though Fund A and B have the same position and exposure to the bond, Fund B is using implicit leverage which adds to the operational complexity of the fund and increases the need for strong cash management controls. Because little cash is put up front for most of these types of derivative contracts, the notional amount can be multiples of the fund assets. Therefore, checking the footnotes of the audited financial statements is the first step to understanding the fund’s off-balance sheet leverage. Additionally, hedge fund investors should understand how the managers are using these derivative positions and whether they are additive to the risk profile of the fund or used as a hedge.
The intricacies of hedge fund financing are a complex part of the operational and risk profile of hedge fund investing. Investors should be aware of both the explicit and the implicit leverage that their hedge funds are using. Understanding how hedge funds obtain and use both types of leverage can give investors a much clearer picture of the portfolio and its related risks. Now that we are in the prime season for hedge funds to issue their financial statements and send them to investors, it is a great time to crack open that report and learn a little more about your hedge fund exposures.
1 Third Basel Accord, “Basel III.” A comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision to strengthen the regulation, supervision and risk management of the banking sector; Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). 12 U.S.C. § 5301 – 5641.
2 A “margin call” is when the prime broker requires an investor, or in this case, a hedge fund manager, to put more money into an account to cover a negative movement in their portfolio.
Michael Levin, CPA, CAIA
Michael Levin is a Vice President in Investment Operations and a member of the PAAMCO Operational Due Diligence Committee. He is responsible for operational due diligence on new and existing hedge fund managers. From mid-2008 until late 2009, Michael worked in the firm’s London office and was responsible for PAAMCO Europe Business Operations, Accounting, Investment Operations and compliance matters, as well as PAAMCO Asia Accounting and Business Operations. Prior to joining PAAMCO, he was a Senior Auditor at Ernst &Young, LLP, where he audited a wide array of investment companies. Michael graduated from the University of California, Santa Barbara with a BA in Business Economics with an emphasis in accounting.
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