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These dynamics place additional pressure on margins and are leading managers to seek new growth strategies. 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, resulting in changing economics for fund managers who finance trades through prime brokers. 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.
Michael Serota, Global Leader, Hedge Fund Services at EY, says: "These dynamics are the newest challenge to an industry that continues to grapple with margin compression, heightened competition for asset growth and ongoing requirements for technology investments. All forms of financing are becoming more expensive for a majority of managers, and these costs have 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."
Regulatory changes have 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 per cent have purchased highly liquid securities as cash alternatives.
Natalie Deak Jaros, Americas Co-Leader, Hedge Fund Services at EY, says: "Many hedge fund managers are larger and more complex, with increased financing needs. As many prime brokers have less capacity to offer than in the past, hedge fund managers are increasing the number of relationships they have to reduce counterparty capacity risk. We are also seeing the need for hedge funds to dedicate individuals to manage counterparty risk, collateral and treasury functions as a result of these shifting industry dynamics."
Hedge fund managers are beginning to explore non-traditional financing sources outside of prime brokers.
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