Hedge fund managers are feeling the effects of new regulations for banks and prime brokers through increased trading fees and broader changes to their business relationships.
According to Ernst & Young’s 2015 Global Hedge Fund and Investor Survey, these dynamics are placing additional pressure on margins, and lead 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.
The survey report, “The evolving dynamics of the hedge fund industry,” notes that 29 percent of funds surveyed have experienced prime broker price increases in the past year, and 22 percent anticipate future increases.
In particular, fund managers who use distressed credit, fixed income and global macro strategies, which can be balance-sheet intensive for prime brokers, are among those who have experienced price increases.
Respondents to the survey now expect price increases and broker limitations to change the way they trade. This includes a move toward swap-based trade execution, as well as reduced repo financing and overall leverage.
“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,” said Michael Serota, global leader, Hedge Fund Services at EY.
“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 also 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 percent have purchased highly liquid securities as cash alternatives.
While prime brokers have suggested that hedge fund managers should concentrate more business with them, 60 percent of managers who were affected by higher prices have added more prime broker relationships; only 12 percent reduced their prime broker relationships.
Natalie Deak Jaros, Americas co-leader, Hedge Fund Services, at EY, said that as prime brokers have less capacity to offer than in the past, large hedge funds with more complex financing needs 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,” she said.
In addition, hedge fund managers are beginning to explore non-traditional financing sources outside of prime brokers, with 13 percent of respondents stating they plan to seek financing from institutional investors, sovereign wealth funds or other hedge funds in the next two years.
To counteract the pressure on margins, 57 percent of managers said their top priority remains asset growth by adding new hedge fund strategies, identifying new investor bases and increasing penetration with existing investors.
New product launches, which was the top method for achieving growth in last year’s survey, has dropped to less than 20 percent this year, as 24 percent of managers reported that new products had a negative impact on operating margins.
“It is an era of rapid change across the financial services landscape, and the hedge fund is clearly in the process of transforming itself, with managers increasingly moving toward a multi-product model, while continuing to focus on issues such as growth and talent acquisition,” said Jeffrey Short, partner and wealth and asset management leader for EY in the Bahamas, Bermuda, British Virgin Islands and Cayman Islands.
Infrastructure investments are underpinning the transformational change. About 70 percent of managers are expecting to make major investments in trading operations, enterprise infrastructure or risk management systems, and respondents project to allocate 12.4 percent of their overall expense budgets to technology over the next three to five years.
The survey findings will be one of the topics at EY’s Global Hedge Fund Symposium in Cayman on Dec. 10.