Hedge Fund Leverage
Hedge Fund Leverage | Prime Brokers
One of key functions of prime brokers is to provide financing to its hedge fund clients, so they can acquire the leverage needed for their strategies. Since with leverage can come increased risk, the prime broker generally determines the degree of leverage that can be extended to hedge funds using a combination of stress-testing and value-at-risk, on a portfolio by portfolio (or client by client) basis. Due to the recent credit crunch, "Leverage is being closely watched," said Josh Galper, managing principal of Vodia Group, which advises hedge funds on borrowing strategies. "…the amount of leverage being utilized is being reviewed much more carefully than it has been in the past, for obvious reasons." (See article from MarketWatch)
There are two major methods that a prime broker can lend leverage to a hedge fund. The first is by providing margin financing; in other words, the hedge fund borrows some portion of the security's value from the prime broker. For example, the hedge fund holds a portfolio with a value of $100, using $25 million of its own assets and $75 million of margin debt provided by the prime broker. This way the hedge fund achieves a leverage of 4 to 1 (assuming only long positions), and the prime broker gains interest on the debt.
The alternative way of extending leverage is through the OTC derivatives. While the structure of this form of financing varies, one approach takes the form of a managed account swap, and is usually termed "synthetic prime brokerage". The prime broker sets up an account advised (or managed) by hedge fund manager who has trading discretion. So different from the first method, in this case even though hedge fund managers trades the account to implement the hedge fund's strategy, the portfolio actually belongs to the prime broker. The prime broker then enters into a total return swap with the hedge fund, and charges the interest in the form of a swap payment received from the hedge fund.
Through this synthetic prime brokerage service, the leverage used by the fund is determined by the amount of margin on the swap required by the prime broker. To follow the example above, the prime broker has an account with $100 million of its own assets. The account is advised by the hedge fund manager, where the hedge fund is the counterparty to a total return swap on that account. As margin for the swap, the prime broker requires the hedge fund to post $25 million of equity; thereby providing leverage of 4 to 1.
Many hedge funds use synthetic prime brokerage service as part of a full service prime brokerage agreement - with equity swaps used side by side with stock loan and other services for particular parts of their portfolios, according to an article by HedgeWeek.
Source: Hedge Funds and Prime Brokers